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UBS AG (NYSE:UBS)

Q2 2007 Earnings Call

August 14, 2007, 3:00 AM ET

Executives

Marcel Rohner - Group CEO

Clive Standish - Group CFO

Thomas R. Hill - Chief Communication Officer

Matt Spick - Deutsche Bank

Analysts

Claudia Meier - Vontobel

Christian Stark - Cheuvreux

Kilian Maier - Neue Zürcher Bank

Christopher Wheeler - Bear Stearns

Jeremy Sigee - Citigroup

Ivan Vatchkov - Credit Suisse

Kian Abouhossein - JP Morgan

Matthew Clark - Keefe, Bruyette & Woods

Derek De Vries - Merrill Lynch

Meredith Whitney - CIBC

Kinner Lakhani - ABN Amro

Anke Reingen - Execution

Stefan Stalmann - Dresdner Kleinwort Wasserstein

Presentation

Unidentified Company Representative

So good morning everybody and welcome to the Second Quarter Results Presentation for UBS. Just waiting for the last people to find their seats. Okay, so as in most of these presentations, the following discussion contains forward-looking statements and our actual results may of course differ materially from our expectations. You can find additional information in our second quarter report and elsewhere. And please pay attention to this famous statement we put up on the screen as normal.

So, with that piece of housekeeping out of the way, I'd like to hand over to Marcel Rohner, Chief Executive of UBS.

Marcel Rohner - Group Chief Executive Officer

Good morning everybody. I am very pleased to be here today with all of you to announce another set of record results, which shows our strong position in the industry and also our well balanced business model. This was our best quarter ever. Even without the contribution from the sale of the 20.7% stake in Julius Baer, which contributed 1.95 billion Swiss francs pre-tax profits, our results contain a lot of parts of which we are particularly proud. But also a few areas which we are not satisfied with.

Let me give you a high level summary by looking at our key performance indicators for the financial businesses without the impact of the sale of our stake in Julius Baer and the DRCM closure charge to show the underlying operating performance of our businesses. Let's look at the right hand column of this presentation, which shows the result excluding these two extraordinary items. Post-tax attributable profits from financial businesses were at the record 3.46 billion Swiss francs. The return on equity was 29.8% for the first half of the year excluding JB and DRCM, up from 29.3% in the first quarter.

The cost income ratio improved slightly on the quarter to 68%, and our diluted earnings per share rose 23% year-on-year to 1.84 Swiss francs, or 14% up from the last quarter.

Let me now point out the areas which have shown particularly strong performance. Wealth Management International in Switzerland have achieved their best ever net profit before tax result. Its net new money grows at unprecedented levels and drives the growth of our asset base, which is at the highest level ever for the bank as a whole. Wealth Management U.S. has very strong revenue growth and ranks number two in terms of net new money as a percentage of assets and also in terms of net new money per individual financial advisor.

Our Business Banking shows a strong 11% improvement from last quarter and the best result ever. When you look at our Asset Management business, we see the highest underlying pre-tax profit ever at 450 million Swiss francs. In the Investment Bank, our investment banking department continues to perform very strongly on a year-to-date basis. IBD ranks fourth in global fee pool, ranks third in M&A, second in equity capital markets and sixth in debt capital markets and ninth in global syndicated finance.

The Equity Business remains one of the best in the world, retaining a top position in most markets. In the first half of '07 versus last year, it grew by 21%. All of these areas, we are very, very pleased about. They are the strong parts of our record set of results. However, we also do see challenges in our numbers.

In Wealth Management U.S., we are not yet where we want to be in terms of our profitability, as costs in Wealth Management U.S. were influenced by higher litigation expense. Our net new money result in Global Asset Management, which was negative highlights the challenges we had with the investment performance in some of our core capabilities. Fixed income, but specifically our rates at DRCM business were disappointing and we are clearly not satisfied with. DRCM contributed approximately a negative revenue of 230 million Swiss francs. However, the books on our transferred dispositions will be managed on an integrated basis going forward, and we have therefore closed this failed initiative.

Generally, we see a flattening of our cost development, but we are not satisfied yet where we are in terms of our efficiency. I do strongly believe that we have taken the right measures to address all of these weaknesses going forward, which have taken the edge off in otherwise terrific set of results.

And with this introductory remark, I would like to hand over to Clive Standish who will give us some more details. Clive, over to you.

Clive Standish - Group Chief Financial Officer

Thank you, Marcel. Good morning ladies and gentlemen. So Marcel has started telling you about our record profits. Our balance sheet remains very robust. Our hiring has slowed. Our market and credit risk remains moderate in the context of both the size and the profitability of the business. I'll now give you some more details on the numbers.

We continue to gain market share in our Investment Banking business. Our wealth and asset management fees continue to grow inline with invested assets. As a result, fee and commission income rose 10% versus the prior quarter to a new record of 8.1 billion Swiss francs. Net income from interest margin activities reflect creditably on growth in secured lending, in wealth management and growth in the Swiss mortgage business. However, we were not immune to difficult trading conditions in some areas.

Net income from trading businesses fell 25% on the quarter to 3.1 billion Swiss francs. This includes a negative revenue number of 230 million Swiss francs from the DRCM positions taken over by the Investment Bank.

Other income, which is part of the credit, treasury and other income chart on the bottom right of this slide increased due to the gain in the sale of our stake in Julius Baer of 1.95 billion Swiss francs pre-tax. Without this, other income would actually have been up slightly from second quarter 2006, mainly due to the Euronext gains and other revenues from the sale of financial investments. Overall, operating income for financial businesses was another record at 15.7 billion Swiss Francs, or if you strip out the Julius Baer component, 13.7 billion Swiss francs.

Across the Group, we are increasing our emphasis on cost control. As you appreciate, the big drivers of costs are people and people growth has slowed down. In the Investment Bank, the growth is entirely related to the reintegration of the DRCM personnel. In Wealth Management, growth is mainly in Europe and Asia and more than half of that relates to the expansion in client advisor numbers.

Second cost driver is general and administration. In here, the other number was high because of a litigation charge for Enron in the Investment Bank and an increase in legal and litigation expenses in Wealth Management US. Travel and entertainment as well as professional fees were also up. The increase was driven by deal-related legal expenses, IT consultancy fees as well as management consultancy expenses. We're not satisfied with these trends, while we are happy with our personnel development. There is clearly more work that we can do on this G&A line.

Cost/income ratio; overall though our cost/income ratio has improved again, the headline number improved to 62%, but clearly this is impacted by the Julius Baer stake sale. Without that sale, and the DRCM closure charges, the cost/income ratio would have been 68%, still an improvement on the first quarter 2007. We are convinced that with further concentration of expenses, we can improve our cost/income ratio in the coming quarters, assuming of course our return to a more normal trading environment.

The effective tax rate for the second quarter was a low 10.9%. This benefited particularly from a very low tax rate on the sale of Julius Baer. Excluding the tax effect of the Julius Baer sale and the closure of DRCM, the tax rate would have been 17.7%. We do believe however that the tax rate for the full year 2007 is more likely to be in the same region as last year's tax rate, which was a little over 19%.

Return on equity has reached 33% for year-to-date compared to 29.3% for the first six months of 2006; stripping out the Julius Baer sale and the closure of DRCM; that would normalize back to 29.8%. This high return on equity allows us flexibility in capital management. We bought back 11.8 million shares in our new buyback program during the second quarter. Tier 1 ratio was a strong 12.3% on the 30th of June, 2007 even after the buyback that's up from 11.7% on the 31st of March and a growth in risk weighted assets on the balance sheet of 7%.

We are committed to further buybacks in line with our new three year program. As previously stated we have earmarked the after tax proceeds from the sale of Julius Baer to the buyback program. During the last quarter, we have brought back 900 million Swiss francs of shares and since that time, the buy back has continued as well.

Credit loss situation, our underwriting criteria and risk preference have remained entirely stable throughout the quarter. The credit line at Group level showed a recovery of 14 million Swiss francs.

Moving to market risks; average VaR was the same this quarter as last quarter, both for the Investment Bank and for the Group, but was lower at the end of the quarter compared to the beginning of the quarter. Our system for estimating risk is robust as is clear from the fact that we have no back testing exceptions. However, the third quarter has seen some extreme market dislocations and these are likely to produce some back testing exceptions we believe.

So just in summary, profits are at a new high, our balance sheet is very strong, very robust, hiring has slowed and our market and credit risk remains moderate in the context of the earnings power of our business. So with that, I will now ask Tom to go through with some more details in each of the business groups.

Thomas R. Hill - Chief Communication Officer

Thank you, Clive. So to summarize, our underlying profits from all business groups remain strong and going forward cost control remains a priority.

Looking first at Wealth Management International and Switzerland, you can see that it produced record profits and very strong net new money, with strong increase from all regions. This was the second best quarterly results ever for net new money. The total was 32.7 billion Swiss francs for the quarter and for the first half, net new money totaled 66.6 billion Swiss francs, which was an annualized 12% of invested assets at the start of the year and 21% more net new money than in the first half of 2006.

In terms of profits, our profit was up 3% on the quarter, or 20% on the year at 1.54 billion Swiss francs. Our income rose by 4% but costs rose by 6% against the prior quarter. Within that, the front to back ratio improved and the number of people was up by 507 or 4%; of which class advisors were up 292 or 6% on the quarter. Nevertheless, expenses did rise faster than income, but we are aiming for the cost/income ratio for this business to resume its improving trend over the next year or so.

Moving onto European Wealth Management; this business is making progress. For example, the number of class advisors rose by 50 or 5% over the quarter, and invested assets rose by 7%. For the first half, while still it's more in absolute terms, profits have risen substantially on the first half of last year and these trends are consistent with the stated development of this business.

Wealth Management U.S., we continue to expand the business. Net new money was 2.5 billion Swiss francs for the quarter, which is the second highest quarter in recent history. This is down on the first quarter, but absolutely inline with the historical pattern as the second quarter is when U.S. taxes are paid by our clients. Invested assets rose by 3% to 898 billion Swiss or $736 billion U.S. and the gross margin on invested assets grew by one basis point to 77 basis points. And as a result of those trends, total operating income rose 5% on the quarter and compared to the same quarter last year, total operating income was up by 23%. This growth and the 4% increase in invested assets I showed you a moment ago validate our expansion plan.

To deliver these revenues, we've continued to invest in people, people numbers are up 1%, although financial advisor numbers are static. But as already mentioned, there has been a significant increase in G&A expenses, which were up 29%, more than half of which is because of the increase in legal and litigation expenses. As a result of this, the cost/income ratio rose to 90.4% and we'd expect to see this ratio resume its downward trend in coming quarters.

As I told you when we reported first quarter results, the cost/income ratio in this business is about 2 percentage points or 3 percentage points higher because of the planned investments in the platform. And on top of that higher level, you've got an increase in the litigation and legal expenses that led to the overall increase in the cost/income ratio.

Looking at Business Banking Switzerland, this continues its smooth and steady growth. Profits were 637 million Swiss francs, up 11% against the prior quarter and of course that doesn't include the returns on the assets that had been shifted to Wealth Management. And if those were included in Business Banking, profits growth would have ran at over 10% compound over the last few years.

Turning to Global Asset Management; Global Asset Management's profits are at a new record adding back that what... restructuring charge for DRCM. This figure was 384 million francs pre-tax and without that, profit would have been 450 million Swiss francs, which is up 11% compared to the first quarter of the year. And the cost/income ratio again excluding the DRCM closure costs, improved to 59.5% for the first quarter to 58.3% in the second quarter.

The net new money outflow in Global Asset Management has been significance. This follows a period of underperformance in the core equities... core global equities capability and we have made some management changes to address this. And we intend these changes to reverse the trend in net new money and performance in the medium term.

To give you the figures, the overall net new money outflows amounted to 3.2 billion Swiss; excluding money market close which for the record were a net inflow of 1.2 billion. Of that, institutional channel recorded outflows of 4.6 billion francs, of which 1.5 billion was paid back to DRCM outside investors, but the wholesale and intermediary channel recorded net new money inflows of 1.4 billion Swiss francs. On the other hand, as mentioned, profitability continues to improve and the gross margin, both for intermediary and wholesale businesses rose to 48 basis points, as you can see on the chart on the screen.

Looking at the Investment Bank; well, the investment bank profits are at another record high. IBD has continued to perform very well with record revenues and further gains in market share. In the first half, IBD share of the pool was 5.8%, up 0.9% in the 4.4% achieved in the first half of 2006. Equities revenues were up 36% year-on -year, or about static on the quarter, and we retained our top rank positions in most markets. However, fixed income revenues fell 31% year-on-year, or 20% on the quarter. That of course includes the DRCM results and excluding this, revenues would have been down 4% year-on-year and down 16% quarter-on-quarter.

Looking at fixed income in more detail, picture is of course mixed. Credit fixed income has made further progress achieving a record. But particular gains in leverage finance, global credit trading and proprietary strategies. In the context of a full in commodities prices, NCC sort of declined in revenues of 18% on last year, with strength in FX and money markets outweighed by declines in commodities, within which precious metals and natural gas fell, but crude oil and commodity structure products rose. Rates on the core DRCM declined.

Over the last 12 months, fixed income revenues excluding DRCM have grown by 8%, but this is a slower growth rate than we have been aiming for. As we announced recently, we have made some management changes, with Andre Esteves taking over fixed income business going forward.

We have continued to focus on costs in the Investment Bank. The number of people was up only 1% on the quarter, all as a result of the reintegration of DRCM staff. Total costs fell 1% in the quarter, even though G&A rose 24% in the quarter, reflecting in particular of the costs of the settlement of the Enron litigation.

Our Corporate Center results from continuing operations were stable, excluding the gains from the sale of the Julius Baer stake, the loss would have been 216 million Swiss francs compared to the loss of 193 million francs in the first quarter.

So to recap, as you've seen across all business groups, our underlying profits remain strong and cost control remains the key focus, which is being reflected in significant slowing already in cost growth. With that, I'd like to hand back to Marcel Rohner.

Marcel Rohner - Group Chief Executive Officer

Thank you very much, Tom. I am convinced what we've just shown these set of record profits shows that we are working in the right businesses, with the right clients and also in the key countries we need to be present. Of course what's on everybody's mind is risk and many of you have asked me and other members of management and our communications team about our involvement in credit markets and what the effect was of the sale of the July.

Let me start with leveraged finance; with respect to leveraged finance, this market has of course also suffered a serious dislocation recently. Our market share in this segment according to Dealogic is roughly 4%. We are comfortable with our exposures. As our commitments are all relatively small, they are well diversified. They are all mark-to-market and less than half is actually with respect to lower credits. So we are with this type of positions as I said comfortable.

With respect to hedge funds and the lending to hedge funds, as you all know we are a prime broker, a leading prime broker. We work with a wide range of different hedge funds and these clients themselves operate in a wide range of different strategies. So we have by definition low concentration risks, even more importantly, we would like to look at the underlying collateral and again we can say that we have not only very conservative haircuts but also very low concentration list. The collateral is diversified and liquid.

Mainly U.S mortgage-backed business is obviously more challenging and as shown by the write downs we had in DRCM in the first and second quarter. The markets are of course extremely volatile and this makes it naturally very difficult to make any forecasts. I can however say four things about the U.S mortgage-backed securities markets.

Let me start with a general statement. We monitor and manage our risks very closely. We know their positions and we are well within our earnings capacity, which we always derive by an assessment of our exposure works within a wide range of extreme scenarios. Secondly, in July we did experience a significant dislocation in the U.S mortgage-backed securities markets. And despite these choppy conditions, we would say we've achieved satisfactory trading results.

However, in August, we also saw even more turbulent market conditions over the past few days, some extreme price dislocations and generally, a very challenging trading environment which did spread from credit to other financial markets. If these conditions we've seen over the past few days prevailed throughout the quarter, we will probably see a weak trading result in the Investment Bank.

Finally, we have our strong Wealth Management, Asset Management businesses and these businesses will help us under all scenarios due to their very strong and predictable earnings. All in all, this means that if these market conditions prevail throughout the remainder of the third quarter, it seems likely that our earnings in the second half of 2007 are lower than in the second half of 2006.

The results we've shown today are very strong and they are testament to our well balanced business. But they also do show us where we have to do better. Especially, in four areas where I would like to... which I would like to briefly address, its balance sheet and capital management. It is secondly risk management and control, and thirdly talent management, and fourth costs.

So let me start with first one, balance sheet and capital management. The recent events have shown once more what a precious resource our balance sheet, cash flow and funding strengths is. We will use this resource even more carefully going forward and this means specifically that we will apply even more rigorous capital allocation framework and better risk adjusted pricing of the funding of all our activities.

Secondly, on risk management and control, we have a cash rich business and this will always create efficient capacity for us to assume risk. We have everything we need to compete, but I believe we can use our risk capacity more proactively and in a quicker and more nimble way. When it comes to taking advantage of market opportunities and for sure, after a disruption as we have seen now there will be opportunities to come from.

Third, talent management, attracting and developing the best people, but also by moving talent more often between our various businesses, we will enable us to sustain the growth of our businesses, by creating unique opportunities for the most talented of our staff.

And finally on costs, in order to generate profitable growth, improving efficiency, improving front to back ratios, improving input-output ratios have to become objectives and will become objectives against which we measure ourselves and hold ourselves accountable beyond simple cost/income ratios or cost cutting exercises.

My areas of focus do not represent changes in our growth priorities. We run our businesses by identifying the needs of current and prospective clients that help us to identify growth opportunities. Our view of client needs has not changed. If markets recover, we are very well positioned to continue to grow profitably. If markets continue to deteriorate, we will see opportunities to expand our market share. And if anything in a continued deterioration, we will accelerate our strategic progress.

Ladies and gentlemen, with these I am at the end of my comments and thank you very much for the attention. I think we will run a little bit on more than the 28 minutes planned but we will now are available for you to answer questions.

Question And Answer

Operator

So we'll take questions first from analysts either in the room on the phone.

Claudia Meier - Vontobel

Claudia Meier from Bank Vontobel. I have two questions if I may. The first one is on DRCM. Can you confirm that those 385 million we have seen is now old? I mean this is above the 300 million you have guided so there is no more to come and secondly, still on DRCM, the 230 million we have seen that you have booked in fixed income revenues within the Investment Bank; is this out of about 1 billion DRCM funds you have disclosed? So this would be the first. And the second question I would have is on Investment Bank. I have been very pleased to see how strong the Investment Banking revenues have hold up. There was a lot of talk on Ken Moelis leaving and to be a key rainmakers of probably you can follow up on this one. Thank you.

Marcel Rohner - Group Chief Executive Officer

Let me start with the second question and then I will hand over to Clive. He will give you all the details on DRCM. With respect to our Investment Banking department, I can indeed say that we are extremely pleased with where we are today. The Investment Bank has shown 50% and 62% growth rates quarter-to-quarter, year-on-year and we have seen that by the time Ken Moelis left, we have already established ourselves very firmly as one of the leading investment banks with year-to-date ranking number four in the worldwide IBD fee pool. And this shows the bench strength we currently have in the system and it shows that we are also resilient against departure of individuals who clearly have a very important position in there. This was about a position we were aiming at when several years ago we have embarked on our organic growth of the Investment Banking business and this is now a very, very satisfactory, pleasing actually result. On DRCM, can you give the breakdowns? There is a whole range of number so.

Clive Standish - Group Chief Financial Officer

In the results presentation of Q1, we actually flagged that we are restructuring charge for DRCM. We said that we felt at that stage, it will be about $300 million. In actual fact, it is $314 million, which translates into that Swiss franc number of 384 million Swiss francs. That translates in the post-tax number of 229 million Swiss francs. All of that number has been booked in the second quarter. So there will be no booking of anything in the third quarter at all. The other side of the equation with DRCM, we said in the first quarter 2007 that they were negative revenues related to DRCM of 150 million Swiss francs. And in the second quarter, we disclosed that there are negative revenues of 230 million related to those portfolios. The DRCM portfolios are now fully integrated within the investment bank. And so will not be disclosed separately going forward, but will obviously be part of the trading numbers within the Investment Bank in subsequent quarters.

Claudia Meier - Vontobel

Sorry, may I have a follow up on this one?

Clive Standish - Group Chief Financial Officer

Yes.

Claudia Meier - Vontobel

So if this has now everything comes through or is there still something coming through probably in the Investment Banking number within fixed income in the third quarter on the 230 million you have alluded you had in second quarter? So I understand it's now fully integrated. I would like to know is there a probability that you will have to take further right tax on the portfolio?

Marcel Rohner - Group Chief Executive Officer

If I can just put that in context of the risk situation, we were obviously not just DRCM, hedge fund in the fixed income businesses, we are also broker dealer in the mortgage back securities business all along the way. And in that sense, we clearly have exposures in both parts of our businesses and these positions and these businesses they will continue to be there and in that sense, we are exposed to market disruptions in this area. Within the context of our risk management, risk control framework, the way I have alluded to in my closing remarks and this basically is the situation where we are currently are, pretty much along the line of the industry.

Claudia Meier - Vontobel

Thank you very much.

Christian Stark - Cheuvreux

Good morning, Christian Stark from Cheuvreux. Can you just maybe give us... first question would be just on some updates on the sub-prime exposure beyond DRCM? What are your exposures are particularly with regards to conduits with CTO sub-prime underlyings? And the second question would be on DRCM as well. In terms of the people that you've moved over to the Investment Bank, as to your indications to-date in terms of retention of those people and the third question regards your return on capital employed within the Investment Bank, which despite DRCM sort of turbulences have still remained at about 30% pre-tax. Could you give us maybe some indication on your sort of view in terms of long-term sustainability or where you see sort of the returns over a longer term period because currently clearly the market is expecting very little in terms of returns in that business?

Marcel Rohner - Group Chief Executive Officer

Yes. Let me just put the first one a little bit into context and I have to say you, I think you'll understand that in these market environments and conditions with particularly the key into disclose our trading positions and where we do have paper and we don't have paper and which is why we try to put it in context that I would risk control framework which is what we have done. I can say that we do know the positions. We monitor them very closely. We are also very, I should say very cautious in terms of the analysis of our risk. I think standard characteristics such as ratings and similar things have to be taken with great cautiousness because they are underlying concentration risks. We know all of them very well and my statements says within these exposures, which we monitor closely, manage as practically as you can in very choppy markets where some of the markets disappear. We are well within our earnings capacity as I have said before.

In terms of the people from DRCM, I mean that is a strategic answer and then maybe some more color on the DRCM path from Clive. Strategically, we could retain very talented traders and risk takers from that business to be now fully integrated in our Investment Banking business and in that sense, we clearly see that from a pure IDB perspective, clearly as a strengthening of our bench in that business, especially now under the leadership of Andre Esteves. Clive?

Clive Standish - Group Chief Financial Officer

Yes. In terms of the personnel in the Dillon Read businesses, there is just under 300 people in Dillon Read. Of which about 230 of them will... what could be broadly described as front office traders type on the dealing desk and the balance accountants and some business unit controllers. Of the 230 people, 122 have moved to the Investment Bank, and the balance have left UBS. So that 122 will obviously aid in both the management of the DRCM portfolio as being move backed into the Investment Bank and as part of the broader trading platform for the Investment Bank.

Thomas R. Hill - Chief Communication Officer

There was a question on return on capital.

Marcel Rohner - Group Chief Executive Officer

Return on capital, I'm sorry I haven't answered that one. What we clearly see once more that we are substantially ahead of our through the cycle minimum level they will currently is always calculated on a regulatory capital allocated, there will also be changes coming up for individual businesses with the introduction of Basel II and new rules as of 1st of January in 2008, but generally we feel that the due to the cash generative nature of a lot of our businesses, we will see these high level of return on capital deployed be sustainable.

Christian Stark - Cheuvreux

Specifically on the Investment Banking side, you see big deteriorations or do you... how comfortable are you?

Marcel Rohner - Group Chief Executive Officer

I'm comfortable with that given current measurement of the framework; if the frame work changes to Basel II, we will have certainly adjustments in the return on equity numbers there, but I can't tell you exactly what they are currently because it depends on the positions we would have on the books at that point in time.

Clive Standish - Group Chief Financial Officer

I mean, can I just make some comments on it. Remember I mean if you look at the sort of UBS Group wide basis, our KPI for return on equity is 20% plus through the cycle. So we actually do think about the cyclicality of the various businesses, particularly the Investment Bank. As you have seen from this quarter, our return on equity is just a little bit below 30%. So if the scenario that Marcel has outlined does come to part, where we see more difficult trading position in the Investment Bank for the third quarter; that is but one part of obviously the UBS portfolio of businesses. So we would still very much see ourselves out competing against our KPI on an annual basis.

Kilian Maier - Neue Zürcher Bank

Kilian Maier, analyst with Neue Zürcher Bank. I would have two questions, the first one, maybe you could elaborate a little bit on your strategy to bring down G&A expenses, especially in the Investment Bank? And the second one maybe you could comment on the general credit environment retail corporate in Switzerland and rest of the world?

Marcel Rohner - Group Chief Executive Officer

Well I should say to begin with, the broader more strategic question the second one that we feel pretty positive about most fundamentals we've observed in the world economy. I mean world economy is pretty healthy, we see a good corporate balance sheets, we see good corporate earnings and I think we have seen also when we looked at these markets this option that usually the spreads for what's a solid underlying business have come back to more normal levels relatively quickly. In Switzerland, we see still a growing mortgage business, a very healthy business, a very competitive business and we're pleased with the development so we could say that spillovers as they were... from some market participant seen as possible in the past, we clearly haven't observed here in Switzerland and Europe and elsewhere in the world.

And on G&A expense, just one thing before I hand over to Clive clearly in terms of strategically to address it, it is a question of front to back ratios. What do you really need to support how many people you have serving clients and this is the direction now we want to tackle it strategically, but specifically on this G&A Clive?

Clive Standish - Group Chief Financial Officer

Yes, if we look at the G&A line, in this quarter they are few sort of one-off items, if you like. We showed the slide earlier on when I was talking about the breakdown in G&A and I will quickly just go through that give you sort of flavor for how that's developing. The sort of big outlier this quarter is in the bucket called other. Other is mainly legal and litigation expenses. In the quarter, we saw the culmination of the Enron litigation situation, where we booked a final number against Enron of 115 million. Clearly from time to time, there will be legal litigation charges, but they are sort of lumpy by their nature. So and of course we hope they won't occur again forward, so that will be one thing. And a lot of the other drivers within the G&A line are a little bit more controllable though.

Within number of the quarter, there is some of the DRCM restructuring costs actually go through to the G&A line. Plus of the 384 million of the DRCM restructuring cost, 318 million of that was actually personnel, the rest was related to IT, premises etcetera and all that drops down to the G&A line. So we would not expect that to recur going forward.

We do have a slightly higher elevated amount in consultancy or professional fees line. This relates to in particular to IT consultancy as part of some of the development and infrastructure franchise development in the Investment Bank. Again we would expect that to come to fruition in future. So that line should go down and then we've seen a very active marketplace in Investment Banking particularly in mergers and acquisitions business on a global scale. And this feeds directly through to marketing expenses in G&A and particularly to travel and entertainment, with high levels of capital markets activity, high levels of M&A etcetera, there is a large amount of traveling that people are doing. So there is a bit that's clearly going to be reflective of market levels of activity.

We are concentrating on the non-personnel items within that G&A line to ensure that we have discipline not only in the Investment Bank but also across our Wealth Management businesses as well.

Kilian Maier - Neue Zürcher Bank

Thank you.

Unidentified Company Representative

Should we take some questions from the line, next, from people on the line?

Operator

We have the first question from Mr. Christopher Wheeler from Bear Stearns. Please go ahead sir.

Christopher Wheeler - Bear Stearns

Yes, got a couple of questions. Good morning. Sorry about that. First of all, can you hear me?

Marcel Rohner - Group Chief Executive Officer

Yes, we can hear you.

Christopher Wheeler - Bear Stearns

Good, excellent. Let's be honest, since John Costas' presented your 2005 Investor Day in New York, telling us about the invested fixed income business it's kind of being the high volt market, we have this ongoing sort of discussion about investments and then costs into fixed income business. Clearly to get in the quarter, you were disappointed; you appear to have underperformed your competitors, although there was this impact of DRCM. Now could you share with us perhaps really what belief you guys were actually estimates when you asked to take on the job of being global head of fixed income and what do you say to him about what you already want to achieve say in the next 12 months, that's my first question. The second question really comes back to the global asset management. John Fraser spoke to us back in February I think and alluded to the problem with the equity performance. But just would be interested to get a view from you as to how long this is now going to lag on because obviously the problem is even when you fix equity performance, the actual lag effects on staunching outflows probably takes 12 to 18 months. Actually give us a view on that and what you think the outlook is for the flows into asset management in some kind of normal conditions over next 12 months? Thank you.

Marcel Rohner - Group Chief Executive Officer

Yes, thank you. I will answer the first one and then ask Tom to speak to the performance numbers in the equity business, there is a formal research that is certainly the expert to do that one. With respect to the fixed income business and the appointment of Andre Esteves; first of all, we are obviously pleased to him an executive, who built together with his partners an extremely successful operation in Latin America and Brazil in a very entrepreneurial way. And the way they work in an integrated way, the way they managed the business there is clearly a kind of a showcase on how you could actually run a trading and investment banking operation. And they were active traders in these local markets very successfully. They still are and I think many of these characteristics I think they translate very well into the businesses we are now in. So, we are obviously very pleased with that.

When I speak to him, which I by the way do regularly and I have just been in Brazil on a business trip the other week, I will clearly... we clearly agree both of us that the way we deploy our funding resource and that's what I have alluded to at the end of my presentation is a critically important factor in running the fixed income business and that's clearly what we've done in it far too less differentiated way. And that basically drives what kind of assets you end up, the kind of trading strategies you end up within a fixed income business and this is one of our first focus points together with Clive and Huw Jenkins from the Investment Bank, we introduced funding framework which is much more aligned with respect to the risk inherent of the strategies which are to be formed, with the term structure of the strategies which are to formed, the pricing and the transfer pricing we apply in turn. And so there is clearly something we will have to look at.

And secondly we were obviously given time to look... any time to look at the business in depth to understand how he wants to carry it forward and listen to his insights with respect to strategies, with respect to the structure and themes involved. And there I think he is just a few weeks into the business and we'll have to give him a little bit of time until he comes up with what he wants to do. And last not but not the least, we also clearly agree on maximizing return on risk with a clear view on the tail risks involved in the strategies and fixed income businesses are more skewed than other businesses and that's something which we'll pay high attention to as well. Tom?

Thomas R. Hill - Chief Communication Officer

So with Wealth Asset Management's --.

Christopher Wheeler - Bear Stearns

So I guess just follow up just really, but just in short --.

Thomas R. Hill - Chief Communication Officer

Well, I mean the performance is disclosed in terms of the out performance and under performance each quarter in the quarterly result, in the quarterly financial report. And as close readers of the report will have noticed, it's been underperforming for quite some quarters. And it's only now that we have begun to see this resulting in significant net outflows. This quarter, we've changed the leadership within the core equities capability and also recruited some new core equities mangers and actually in the quarter, the performance has begun to improve. But there are necessarily leads and lags in this business. And so we should assume that it will take some while before the effective the improved investment management team should lead to drew performance on a sustained basis and therefore to improve the money flows.

Christopher Wheeler - Bear Stearns

And how should we think that... are we looking at 12 months or we looking this is something longer than that you think so?

Thomas R. Hill - Chief Communication Officer

I think it's anybody's guess, but I mean the historical pattern not just for us but the whole industry is it takes several quarters of improved performance before this affects the professional market for pension funds and so on.

Thomas R. Hill - Chief Communication Officer

Thank you.

Marcel Rohner - Group Chief Executive Officer

Next pending question.

Operator

Your next question is from Mr. Jeremy Sigee, Citigroup. Please go ahead, sir.

Jeremy Sigee - Citigroup

Thank you, good morning. Two questions please. One is could you talk about the mechanics of the DRCM and those losses and sort of very sub questions for that. Number one, ROE losses on sub-prime, number two are the losses reflecting the mark-to-market or mark-to-model and number 3, have the positions been trimmed at any point or are they just being maintained as they were in sort of held to majority? And so if you have could talk about the mechanics of DRCM and then second question switching to the private bank, we are seeing but quarter-on-quarter, taking year-on-year a decline in the gross margin trends including the recurrent income and I just wondered if you could talk a bit more about that what the drivers are and what the outlook is for that?

Marcel Rohner - Group Chief Executive Officer

Well let me start with the wealth management business first. I mean here we can clearly say that the only way to sustain the 45%, the 55% net margin is to basically run an exclusive offshore business and the fact that we are growing the business world wide means that the we are actually growing the business in markets where we will potentially end with the net margins which are around 35%. When we look at gross margins on the business, we can actually say that despite the fact that we have a disproportionate growth in the ultra-high net worth business, was actually has a lower gross margin we could maintain it at a relatively constant level which speaks for the fact that we have continuously expanded the diversification of our clients portfolio in a number of new asset classes which is one of the strategies which we deploy for our clients. And before we are going to the DRCM evaluation, to just say in terms of the risk management of the product, this is not just the transfer A to B and they are not doing anything. Clearly, we manage the exposure, we reduce exposure, hedge exposure as and if opportunities arise, but at the same time it's also clear as everybody knows in these fixed income markets, managing these positions through these turbulent times is a very challenging undertaking. Clive, on the mark-to-model, mark-to-market?

Clive Standish - Group Chief Financial Officer

Okay, just some comments on that. Within the DRCM portfolio, they were not just sub-prime portfolios. There were some other portfolios and they are related to our real estate and other bits and pieces. Predominantly they were sub-prime. And in terms of the question about are they mark-to-market, are they mark-to-model. The whole issue about being marking portfolios is one that we put a massive amount of focus and emphasis on. And as the CFO, the person has to front tap to the audit committee and get absolutely grilled by the audit committee on the fair value of our positions in the investment bank. This is something that my finance team put a lot of emphasis on.

Our first order of priority is wherever possible to get a marking which is completely transparent. I mark to a price that is observable within the marketplace, and the vast bulk of our positions are marked to market in that sense. Where we cannot get an observable price in the marketplace within the full pact of various other mechanisms and notably mark-to-model where we then have to validate against that model. That doesn't mean that we just look at our own model and go, that's fine, we actually then do a lot of price testing relating to the validity of that mark-to-model. I can say that the vast bulk of observations in mark-to-market and there is obviously a percentage of that is mark-to-model by validated by at certain price testing mechanisms as a result of that.

In terms of your comment about the trend line within the portfolios, clearly, we would like to... as we said when we were transferring the DRCM portfolios from Global Asset Management to the Investment Bank that they would be additive therefore to our positions already within the Investment Bank and that it will be overtime reducing down our positions to a level that we felt comfortable with. We have in deed reduced down some positions within the quarter and going forward into subsequent quarters, we will continue that trend.

Jeremy Sigee - Citigroup

Thank you.

Operator

The next question is from Mr. Ivan Vatchkov, Credit Suisse. Please go ahead sir.

Ivan Vatchkov - Credit Suisse

Good morning. I wanted to ask three questions on costs. I'd like to come back again to DRCM and also something on capital. First in cost, if I take a look at Investment Bank, I think over the past seven quarters or so you've only had revenue growth faster than cost growth in one of those quarters and certainly over the last 12 months invariably cost have grown faster than revenues. Can I just ask Mr. Rohner when you speak to Mr. Jenkins, have you outlined any particular timeline over which you like that to reverse, just feel that's not a sustainable position. I guess it will be very reassuring for us to know that there is some kind of deadline and there is rather an open ended commitment to growth. Second question I had was on mortgage of execution in DRCM, just so that we can understand this properly, is there a mechanism by which you think you can actually put it down say protection on this portfolio and this market doing damage to your business? Are hedges available or are they too expensive, is it impossible to hedge? What I mean is what you said is... it sounds like you anticipate further weakness in that market. I think few other players have found ways of actually benefiting from that at least limiting damage. How is UBS different and if you can just sort of outline your thoughts on that? And finally on the buyback, I appreciate the capital is very precious commodity at the moment and I can see why you would want to cautious on deploying that too extensively. But I guess you would agree that perhaps the market isn't fully appreciating growth opportunities reflect in UBS share price, why we then not chosen to I guess signal to market your commitment to improving the share price by buying back some more of it rather than maintaining your term commitment. If you can give some thoughts on that as well would be very helpful. Thank you.

Marcel Rohner - Group Chief Executive Officer

Well, I'll start with the first two and then have some introductory comments and then hand over to Clive for more on share buy back. The cost management as I said is one of my priorities, efficiency management we've already agreed with you that we are aiming at reducing cost/income ratio. But this tells you exactly these days, the limitation of cost/income ratio as an efficiency major, because guess what the cost/income ratio as we speak looks a bit different and it looked three weeks ago because we have very turbulent market environment. So our aim is clearly to work permanently on efficiency improvement along the lines as I said this will be KPI's measuring resources deploy to achieve certain from organization and servicing our clients.

On top of that, there are the stand that initiatives that we have actually or Huw has established within the investment and a while back dedicated cost management function initiatives looks like everything across the board which can be further optimized. So all in all, I think what we did see is a ramp up in terms of the number of people working in Investment Bank. Clearly this has been a response to perceived and still completely valid points where we have opportunities or where we didn't have to strengthen the market position we wanted to have before and what we see come through now is the result of this ramp up, will be predominantly going forward clearly from the back efficiency costs will be very much in the focus.

Then in terms of hedge as well I guess the non-availability of a nice liquid perfectly priced hedge is kind of a description of the dislocation, we have seen in the U.S. mortgage-backed securities market, it is not. If there was one I think everybody have bought it because there is only one thing available in sub-prime market directly it is obvious AVX indices, many people use them. However, they are made up by a small number of underlying securities only 20-25 pounds is actually indices which we usually not even qualified and exchange to be a real index and because everybody use them there are some who would say they are actually quite depressed and then occasionally what happens if you have such a hedge it actually flips back on to positions and stand still on the other hand. So we actually have two problems, one in the position and one in the hedge and that's how the hedging extends then. It becomes less and less correlated to the underlying assets and then you could the ends that there are hedges which you can make up a macro economic scenario says if that goes further then the other thing must go up and the hedges become more and more uncorrelated and then in the ends you have also more and more basis risk to the extended, it's only a long shot position. I think that's the situation everybody is in the marketplace and everybody tries to do their very best on how to do it and its everybody's trading desk secret and how they best manage these positions through these very challenging period. And then just on capital, the fundamental priorities do not change on how we deploy capital along the lines of organic versus non-organic growth. Clive can you give us a bit more insight?

Clive Standish - Group Chief Financial Officer

Sure. In fact, we announced a three-year buyback program last year as you know, and that replace the one-year annual buyback that we had. We announced the three-year program because we wanted a little bit more flexibility year-on-year to the little bit more or little bit year less depending on what was going on in the marketplace. In no way meant there is a dilution to our fundamental policy, which says well where we have surplus capital over and above the needs of the business and the needs of our organic and M&A growth within the business that we will return that to shareholders. So that fundamental discipline applies and we have bought back shares within this quarter 2 being 12 million shares during the quarter. Since the end of that quarter we have continued our buyback though at just at this moment in time, obviously we are close because of the issue of our results. We are free to start buying back shares this afternoon. We will continue our policy, the exact timing of that. I certainly won't tell you on a day to day basis as to how many of that we are going to buyback because I certainly don't want to flag back to hedge funds and other people you may use that against us. But I can say that we are committed to that and we are committed to a sensible capital management program.

Ivan Vatchkov - Credit Suisse

Can I just follow up with one quick question, I am conscious of the other participants who want to ask questions. Mr. Rohner, so I might understand you correctly that I mean I understand the mechanics of cost/income ratios and how they can be quite difficult to manage with regards to specifics, but when you have conversations with Mr. Jenkins on the topic of growth, I mean I guess at some point one has to operate within the limitations of the revenue that one can generate. You started the expansion program at the Investment Bank close to 18 months ago, which I am assuming would mean that a lot of the higher schedule to be reaching full product activity. Isn't there a point of time that which you say well, obviously part of this aren't working out and then look to address the profitability of those new hires from an alternative sort of view point or do you just sort of keep chasing growth opportunities and I'm just trying to understand your thinking more than anything else ?

Marcel Rohner - Group Chief Executive Officer

Well, I mean I think you've given off the answer yourself that is of course an expiration date behind every initiatives to generate growth and the question always is when do you deem this point to arrive or not. When we look at our history, we clearly have this overshadowing of all the developments by the DRCM initiatives and if we adjust for that and take into account that we have now have appointed a new leadership both the business I think it will be way too early to conclude where this is going. I also believe that strategically the businesses we embark are critically important for our position in Investment Banking, which is otherwise so strong and so well established in so many markets and that's why we are convinced that we will get there and we will give it enough time through not an endless, but as a period which covers more than just one segment of a cycle to come to a conclusion I will, it is progressing.

Ivan Vatchkov - Credit Suisse

Okay thank you.

Operator

The next question is from Mr. Matt Spick, Deutsche Bank. Please go ahead sir.

Matt Spick - Deutsche Bank

Good morning. I just had a couple of small questions. One was on your balance sheet, as I comment that you have been contracting it over the last quarter quite sharply due to wind up of the repay businesses from short funded positions. I wondered if you could comment on whether that is part of risk production as you brought DRCM businesses back on board and whether or not you are effectively had a carry business within that repay business and the second question was just as a point of clarification, you said that it was likely that you would have back testing losses in the third quarter. Does that mean you are saying that you haven't had any yet, but you think it's right possible as market conditions continue or are you saying that you have had back testing losses already. Thanks?

Marcel Rohner - Group Chief Executive Officer

So on the first one I can say there is one effect in there which is the netting of our long and complete in-house positions, which is disclosed in one of the notes that the financial statements and that has basically reduced the repo position I think by about 30 billion Swiss francs. Other than that we had some invested... some risk weighted asset growth actually on the balance sheet due to both the lending business and wealth management and mortgage business on the one hand, but also trading businesses on the Investment Bank. And as regards to the question on back testing, I have not seen like the clean report, but I would expect that there are already some clean report means this P&L has to be clean for the intrude a profit, it has to clean for the fee income and then it's compared with the risk measure that defines the exception.

Matt Spick - Deutsche Bank

Thanks.

Operator

The next question is from Mr. Kian Abouhossein, JP Morgan. Please go ahead, sir.

Kian Abouhossein - JP Morgan

Yes hi. Just coming back to first of all, Dillon Read Capital Management, I am trying to understand if you are continuously mark-to-market or if you are taking some resilience in your numbers as well. Because if I look at the sub-prime in the fees, since the end of the quarter they have moved massively, I mean single A spreads have gone from less than five hundred to 20%, meaning that if the bulk of repositions are sub-prime related, mortgage-related there will be material mark-to-market issues still to come in the second half. So based on the spreads that we are seeing today in the synthetic market, is that a correct rational conclusion and is that included in your second half outlook, any dislocation within the old Dillon Read capital market management book? The second question is relating to your overall DRCM book or the old book. If I look at your annual report at 20-F you talked about 88 billion of increase in assets under management on the balance sheet relating to DRCM. I am very interested in your overall assets invested now within your prop trading business, within the UBS Investment Bank? The second question is related to American Home Mortgage, they filed for chapter 11 and you were highlighted in the 10-Q as one of the largest credit facilitators of $2 billion, so I am very interested if you could give us an update considering this company has filed for chapter 11? Thank you.

Marcel Rohner - Group Chief Executive Officer

Well let me start with the first one on marking the positions. As Clive has mentioned before, our positions are now managed on an integrated way, which basically means that we cannot reasonably disclose separate parts of something which is now like an integrated and which is now a trading book, which is managed in an integrated way.

Kian Abouhossein - JP Morgan

But I mean internally and we are 100% sure you split it out as portfolio management. So in a way you could if you would like to?

Marcel Rohner - Group Chief Executive Officer

Well parts of that... our visible but parts of that are not visible and the question is if you have a trading that's responsible for two books and they manage the risk in an integrated way, what would be the purpose if you take one book off with the risk is basically steered for both books together. That's basically the statement we are making. I think this would not be... would not give a reasonable signal. But with respect to your points on where the spreads go and the indices go, clearly, these are the dislocations you have seen end of July. There were actually at the end of today even charge for tender one, we've seen in the first way at the end of March and clearly those dislocations and changes in the prices of the bonds add the resulting ABX indices have an affect on how we mark our portfolios and books. That's what Clive has described and as such they are also part of our outlook statement, the way we phrased it you might have heard that [indiscernible] TV added on late July versus August versus where that outlook and the conditions we've made. That's what it is.

Kian Abouhossein - JP Morgan

Okay, thank you.

Operator

The next question is coming from --

Marcel Rohner - Group Chief Executive Officer

I am sorry there was another one on the exposure with respect to mortgage provided and fundamentally, whenever we do that there are two ways. It is actually funds and audit securitization program and then you will end up with the collateral which is supposed to be there with all the bells and whistling between a lot you can give back if there are already pay downs or not and that's basically where we are and all these risks are included into risk statement and risk assessment I have made before.

Kian Abouhossein - JP Morgan

Sir, you can give us a net exposure considering that the five foot chapter 11 at this point?

Marcel Rohner - Group Chief Executive Officer

No

Kian Abouhossein - JP Morgan

Alright. Thank you

Marcel Rohner - Group Chief Executive Officer

Next pending question?

Operator

The next question is from Mr. Matthew Clark, KBW. Please go ahead, sir.

Matthew Clark - Keefe, Bruyette & Woods

Good morning. Couple of questions; firstly, just wanted to follow up on the timing of your caution... the results may have impacted your caution on the outlook for the third quarter and beyond. I mean it looks as if you had some difficulties, just wondering if they were all last week or whether it's been spread out over the quarter to-date to help this entangle, what are UBS trends, from what are market trends? And then secondly, there have been some reports of quantitative funds getting into trouble last week in particular, just wondering if this is had any impact on A&Q or O'Connor and whether UBS has principal investments in these funds? Thanks.

Marcel Rohner - Group Chief Executive Officer

Well I can give you a little bit more color, I think it is quite helpful to start with if a problem is like a sub-market contained problem and you will always have like other activities which go on as normal. If the market is all over the place and that's when these locations start to spread from one marketing to another market then other offsetting trading strategies and other things, they will obviously no longer work the way they would work in normal market circumstances. That's basically the situation we described and that's what we've had variance from the time the issues started to spread the way from the mortgage-backed securities market. What I can say is that, so what we see is our own hedge fund businesses are the... and our mutual fund businesses are only very, very marginally if at all invested in the sub-prime space and a statistical arbitrage and strategy of the nature you have alluded to and is not directly part of our O'Connor businesses. There are other stats arbitraged that which is part of it which are not the ones you'll refer to. Generally I can say all these effects you see into long shorts and other strategies into market, this is basically one example of when a dislocation starts to spread into other markets.

Thomas R. Hill - Chief Communication Officer

And just for the clarification on the--.

Marcel Rohner - Group Chief Executive Officer

Yes please.

Thomas R. Hill - Chief Communication Officer

On the final part of it. The way you ask Matthew whether UBS had any principal investments in the O'Connor funds, we do not have any principal investments in the O'Connor funds of any materiality.

Matthew Clark - Keefe, Bruyette & Woods

And is the same true for A&Q?

Thomas R. Hill - Chief Communication Officer

Yes, same for A&Q.

Matthew Clark - Keefe, Bruyette & Woods

And then just coming back to the timing issue, I mean the problems that you have been seeing very much last week or that been in July as well?

Marcel Rohner - Group Chief Executive Officer

Well we have now have go back to some of the calendar and start to check when which market moved, but as I said as long as it was contained in one market it was a different situation to when it started to spread out and infected other markets.

Matthew Clark - Keefe, Bruyette & Woods

Right. Thanks.

Operator

The next question is from Mr. Derek De Vries, Merrill Lynch. Please go ahead, sir.

Derek De Vries - Merrill Lynch

Thank you. Yes, I have a couple of questions. First of all, in your sort of private bank your wealth management business. Can you remind us what percentage of the assets under management would be an alternative and then if you are willing to if you can give us sort of more specific breakdown in terms of how much of that might be exposed to some of these corn funds. Sort of follow up to that if you could remind us, of the 1.28 trillion Swiss that you have in the wealth management business, how much of that is leveraged? To what percent of the AUM is leveraged and how does that compared to like the '01-'02 period? And then the final question, just a follow up on Kian's question, I guess I am not sure I understood the answer and essentially, by the time that Q2 booked closed, presumably you had pretty good insight into the developments in July and August, so the Q2 books closed with mark-to-market losses or gains I guess of reflecting the current environment. Is that correct or is the Q2 reflects how the books closed on June 30th and anything subsequent to that would be in the following quarter?

Marcel Rohner - Group Chief Executive Officer

Let's have with the last one, Clive first on how we closed the books Q2.

Clive Standish - Group Chief Financial Officer

It's very clear; our obligation for reporting is to have fair value as at the 30th of June. So that's my responsibility as CFO to ensure the prices fully reflect the market values as at the 30th of June.

Marcel Rohner - Group Chief Executive Officer

And my responsibility and the collective one is to give you today an outlook statement reflective of what we already know, which is the second part of our communication. With respect to our exposures in alternative investment, this is a substantial part; it runs around outside of the U.S, I think 8% of the total asset base of our Wealth Management assets. However, the vast majority, north of 90%, 95% are from the funds and everything which we have basically created from third party assets is well diversified as the first principal to invest assets into this hedge fund portfolios. In there, you will have through one or the other way occasionally a strategy which is exposed either to statistical arbitrage or marginally may be in the CDO usually a non-U.S one, some times there is one, but generally the well diversified nature of these foreign funds will work well specifically in this location even as we currently see. The leveraging I think the penetration of our asset base in terms of collateralized loans, it had around 5% at the moment, we would have to double check that. Everything isn't off the top of my head, what we have not seen is a significant deleveraging on that end, usually these are big haircuts, these are strategies which are based on very broadly diversified portfolios and we have not seen significant deleveraging happening on the private client side.

Derek De Vries - Merrill Lynch

Just as maybe, the 5% you say is currently and will that a bit of same level in 2001 and 2002?

Marcel Rohner - Group Chief Executive Officer

No it's actually it's an area which we have grown continuously over time and you can actually see, it was one of the drivers of our increase in risk weighted assets over the past.

Derek De Vries - Merrill Lynch

Okay, thank you.

Marcel Rohner - Group Chief Executive Officer

Next one.

Operator

The next question is from Meredith Whitney, CIBC. Please go ahead.

Meredith Whitney - CIBC

Good morning. I have two questions. The first is related to the reduction in gross fees earned by both the U.S. Wealth Management business as well as European, and I am sorry Swiss International businesses and can you comment on the year-on-year decline in growth fees there? And then the second question is a broader question, which is can you give us some understanding of your confidence in the fact that after those will be a better manager of fixed income business trading business than Bundy was or Brunt was when it is background in the fixed income market specifically in Europe, sorry in U.S that you are trying to penetrate. Thanks?

Marcel Rohner - Group Chief Executive Officer

Well let me start with André and then well, I will have to ask again what you meant precisely as to first part of your question. But with Andre Esteves, as I said before, he was basically managing partner of Pactual, when we've acquired it, it's now UBS Pactual and it is the leading investment bank in Brazil. He is a very successful both entrepreneur, risk manager and trade and I think the combination of these three achievements make him an ideal candidate for the situation we are in with our fixed income businesses and I'm very confident that he will make a big difference in the way forward. Now what exactly did you refer to in your questions on regarding income, I'm not sure what if I understood what you were referring to?

Meredith Whitney - CIBC

Well, if I could just follow up with the estimates question, so he was accomplished in Brazil, but in terms of larger debt markets what gives you confidence that he has any skill set into the U.S fixed income trading market and then in terms of the growth fees on wealth management business is declining year-on-year, what look to be fairly significant decline year-on-year, if you could comment on those please?

Marcel Rohner - Group Chief Executive Officer

Which fee?

Thomas R. Hill - Chief Communication Officer

Sorry, you can just maybe --

Marcel Rohner - Group Chief Executive Officer

About first one is the fixed income experience; first of all, the Brazilian fixed income market is actually one of the very most liquid and well traded markets. One could say the emerging market fixed income experience is pretty good preparation for the U.S sub-prime market. Clive?

Clive Standish - Group Chief Financial Officer

Just on your margin or what you call growth fees Meredith, if you look at... you will get the answer as if you look through the quarter financial report, the quarterly financial report. But just quickly, in actual fact, in Wealth Management U.S., the gross margin is been for June 2006, 74; March 2007, 76; and June 2007, 77. Within that component, there is a small variation depending quarter-on-quarter between recurring and transactional fees. And that tends in that business to be a bit reflective of market activity. Within Wealth Management International and Switzerland, you are right in the sense that June 2006 had a 107 gross margin and June 2007 had a 103 gross margin and March 2007 had a 105. So if you look that as a trend line you think it's going down. In actual fact, it isn't because within that difference for example, between March and June 2007, the March quarter has an annual booking fee of the trust business which only happens within that quarter and actually is about 2 basis points from my understanding. And so you will see this line going up and down. As an overall comment, and probably your case in this rather than me; that we see this as a sort of 100 to 110 basis point business as throughout the cycle, growing our invested assets based off that. We don't see this 125 because actually we see this is a long term client oriented business which is all about service levels and long term performance.

Marcel Rohner - Group Chief Executive Officer

No, thanks Clive, that's perfectly accurate. Two more effects should be added on this gross margin. First of all, to calculate the gross margin you would have to apply the same client split on the portfolio in terms of outline it or sign it versus collateral as we set and trying to prepare that asset size. A $100 million client pays a different fee than a $1 million client. There will be a return on assets on the very large accounts is small, so if you grow disproportionally in the very large accounts that means the gross margin on the total population will trend down even if it within the clients that going to have an increasing margin. So that's one effect which we have seen. The second effect is second derivative for the mathematically inclined; if the net new assets grows over proportionally you'll have with the delta in growth over the growth last year. So if you have 50 billion last year and 70 billion this year or something like that, the 20 billion adds dilution because these assets come in and they are not invested yet, they don't generate revenues when the assets are booked so there is a time lag until the assets are invested and generate revenues and only then they affect the gross margin, that's if we have such a ramp up in invested assets growth maybe another basis point or so. So all in all, when we adjust for these effects, one Clive have said in booking of revenues and also the mix of the portfolio we actually see a training up return on asset in the sub-segments, as we have shown at our investor day I think about half a year ago, well Tom?

Thomas R. Hill - Chief Communication Officer

That's right.

Marcel Rohner - Group Chief Executive Officer

Okay. Next question?

Operator

The next question is from Mr. Kinner Lakhani, ABN Amro. Please go ahead sir.

Kinner Lakhani - ABN Amro

Yes hi, good morning. Couple of questions on fixed income and then on capital, especially on the former DRCM or part of that PFCA business. This seems to achieve revenues of $300 million to $450 million per quarter. It's a pretty important contribution to the fed business. What would you say is the outlook for this into 2008, is it that positions are being one down so one can no longer consider these historic revenues as being sustainable revenues?

Marcel Rohner - Group Chief Executive Officer

Yes, I would actually say that's pretty much true and would say it is probably true for most like predominantly asset backed securities driven businesses. We clearly see a very strong credit fixed income business; stock to credit has been performing extraordinarily. Then we had in merchant market business which has done extremely well, global syndicated finance business extremely well. These are among the growth initiatives which we have disclosed and invested in and I would basically think that over the cycle, these businesses all become even more important. They will clearly be at one point in time whenever there is, some return to more normal levels in the asset backed markets. But to identify this contribution, the way it was I mean at the end of the day, this was you could say that we had a few golden years in the way you structure and securitize the businesses and have some other balance sheet and they will probably refer to historical PFCA performance. So I will not extrapolate that into the future like that.

Kinner Lakhani - ABN Amro

And just to follow on, I mean clearly your credit businesses have done very well. But against that, the rates business and the... I think it's the MCC business it seems to have gone backwards against both comparable quarters. So is there an element of kind of two steps forward one step back going on there or is that just single quarter?

Marcel Rohner - Group Chief Executive Officer

Well, with respect to the single quarter, yes it's a step back after two forward. We would look at the initiatives over the more extended cycles we were pretty transparent and clear that we are not satisfied with that. And there were you pointed the rates business, clearly and then on the commodities business, its actually precious metals business and the gas business. Gas business dislocation, precious metals business down and low client revenues which have contributed, I mean this one we would just a basically is a difficult time for the time being. But we would expect to come back.

Kinner Lakhani - ABN Amro

Just final question on capital. Would you be able to quantify the impact of volatility on your capital ratios?

Marcel Rohner - Group Chief Executive Officer

As we, of Basel II from the current... from the last real one with real data, we would probably expect a slight reduction in duration. Is that correct, Clive? Can you comment further?

Clive Standish - Group Chief Financial Officer

Yes, I mean obviously we are seeing a couple of effects and have one effects in our business banking, business particularly as it relates to our mortgage activities, where the capital required will go down, but within our Investment Banking business, the capital requirement for operational risk could actually go up during this period. This is still work in progress in the sense that we are doing what we call parallel runs as to what would Basel II to be if you look through our books right at this second for example and we are just firming those up. Overall, it should not have a material impact if anything excludes slightly negative it is little bit more capital. But net-net I think in reality you can look it is a bit of a wash.

Operator

The next question is from Ms. Anke Reingen, Execution. Please go ahead Madam.

Anke Reingen - Execution

Yes, Anke from Execution, thank you. First question is on DRCM, maybe I missed it somewhat. But I have had actually heard what net exposure from DRCM as of end of June or most recent. And then secondly, in terms of the cost of development in the Investment Bank, I'm finding it quite difficult to reconcile what actually the underlying trend is because it seem to refer in the past to ex-DRCM target. So where are we in terms of first half cost/income ratio, and I understand you said, is it not a good to way to look at it, but where are we in terms of the underlying H1 cost/income ratio ex-DRCM and how does this compare actually to the number you set as a target which would be low 2006 ex-DRCM. And then you said, obviously you are still growing your business, have the audit, actual audit already started to stop a number of initiatives in terms of to react to the change in the market. Thank you.

Marcel Rohner - Group Chief Executive Officer

Well, to the exposures as we have said, I mean we do not disclose single exposures or specific exposures and that physically as to are now managed on an integrated way and we try to frame where we are with our first outlook in January all the color and context I provided around with the last few weeks of trading to describe where we are in the most appropriate way. Then the cost/income ratio, I think we said basically it will be lower than last year, and we are actually much, much better than that as of end of second quarter. What was your... and then we go back to the second question please.

Clive Standish - Group Chief Financial Officer

Sure, on the cost/income ratio that does include the effect of DRCM and that's open and honest thing. We think it's real so you can't ignore it. The cost/income ratio for the quarter ending 30th of June was 70.8%, which is down from 71.3% in the Investment Bank in the first quarter '07. But up slightly from 69.5% in the second quarter '06. Our issue there is that we clearly see a reflection in the cost/income ratio relating to our investment spend over the last 18 months or so within the Investment Bank. We are obviously make that investments spend on the basis if we think this will be additive to our bottom line, and so our aim through the back end of this year and going into 2008 is to have a cost/income ratio that improved back to kind of the experience we had pre the investment phase.

Marcel Rohner - Group Chief Executive Officer

Thanks Clive, what was your second question.

Anke Reingen - Execution

Was basically just to confirm on the cost, basically it was Q1 you said your underlying cost/income ratio ex-DRCM was 69%. Is that similar number for Q2? And with respect the other remaining question on cost was basically, if you already stopped or if you were down some of the investment, I mean you mentioned time but is it really your idea with some response to change in markets.

Marcel Rohner - Group Chief Executive Officer

No, not at all, the change... response to change in market. We have said a quarter ago or few months ago that we are about 80% through, we think we have currently about right staff levels for these initiatives. But we are not slowing them down that's just more or less complete in terms of the people hiring. Cost/income ratios, Clive?

Clive Standish - Group Chief Financial Officer

Yes, if you look at this on an ex-Dillon Read basis, my mental gymnastics... math isn't fast enough to actually work it out in my head. But the negative net revenue from DRCM in the second quarter was 230 million Swiss francs. So if you take 230 million Swiss francs of the revenue line, you can then calculate it back and I think that will take that through into 69 something or other.

Marcel Rohner - Group Chief Executive Officer

Okay next question is one more pending?

Operator

The next question is from Mr. Stefan Stalmann, Dresdner Kleinwort. Please go ahead sir.

Stefan Stalmann - Dresdner Kleinwort Wasserstein

Yes good morning. I would like to ask a few questions on the Investment Bank please. The first is as it strikes me is that it seems that your compensation expense is growing at a much lower pace than your headcount. Your average compensation perhaps in the first half is down 9% year-on-year, which I think is quite different from any of your competitors, also from what you know about the revenue environment so far in the third quarter. Do you think that you have accrued appropriately for the first half of the year and then if we look out a bit longer into the Investment Bank next year once markets have settled down, which undoubtedly they will, do you think that things will be back to kind of normal to the run rate of the first half of '07 or late '06 or do you think things will settle down at a slower pace in many of your key markets. And what could that mean for your current headcount and for your current capacity in the Investment Bank, at what point in time do you need to think about cutting back with a view to more medium term development in the market?

Marcel Rohner - Group Chief Executive Officer

Thank you very much for this question, I think it's very relevant. First of all, as I said before we see fundamentally relatively, still relatively positive outlook. I mean you can construct the scenario where crisis extends, and extends and extends and extends and in one point in time, it starts to infect the real economy, we don't think that this point has come yet. We see a healthy world economy, we see strong development in Asia, we see growth in Europe. We have actually a very good deal pipeline in the Investment Banking. In that sense, we believe that the capacity level at which we currently run are perfectly appropriate. And you mentioned it and fundamentally, we do... I don't believe in too much of a yo-yo effect in terms of managing costs. At one point in time, it is a question of capacity clearly in investment banking but we feel that given the environment and the set up we have with our capacity is at the right level. The compensation effect, yes, there was a slowdown in the second quarter; maybe just one channel will comment. We obviously also have hired a lot of people in across all our operations and across the value chain in Investment Banking which has also affected the average count, but on accrual Clive, you can maybe add something?

Clive Standish - Group Chief Financial Officer

Yes, if I could just make a comment to that. I draw your attention to page 44 on the quarterly report. Our compensation ratio for the quarter was in fact in the Investment Bank was 52%, which is down 0.4 of a percent from the same period last year. The way that we approached the accrual for bonus-based compensation in the Investment Bank is that we do it in a relatively mechanistic sense for the first, second and third quarters based off the sort of make up for the business, and then we threw it up in the fourth quarter of the year. Clearly, what we try to do is to make sure that actually we do recruit in appropriate and correct amount so the true up in the fourth quarter doesn't materially change life.

Your question is a difficult one in the sense you say in a given outlook statement in the revenue environment, have we accrued appropriately for the second half of the year. If I truly knew what the second half of the year would do, I could actually make an accurate comment on that. We believe that we have accrued appropriately to reflect what's happened in the first half of the year.

Operator

There are no more questions registered out in the line.

Unidentified Company Representative

Okay. So I think that concludes the analyst Q&A. If there are any more questions from analysts and investors, please contact the IR department. We will take a short break now to allow analysts to leave the auditorium and go back to work and then we'll continue with questions and answers from the media. Thank you.

Marcel Rohner - Group Chief Executive Officer

Thank you very much.

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