UBS Plan Could Be the Road Map for Financials

This week UBS (UBS) unveiled a plan that may just be the blueprint for other banks with troubled loans on their balance sheets.

UBS essentially has placed securities linked to US mortgages into a separate subsidiary. The eventual goal will be either to spin off the subsidiary or, in the short term, sell chunks of it to investors. Doing it this way would remove the loans from the balance sheet and restore critical ratios. Lehman Brothers (LEH) CFO Erin Callahan confirmed the plan when she said on CNBC "we want to continue to move illiquid securities of the balance sheet".

This is somewhat similar to the "Super SIV" fund that was bantered about last summer but never gained traction as the banks bickered about who would contribute and control what. Now that much of the credit crunch has washed through the system, buyers like Wilbur Ross have begun to emerge as buyers of mortgage assets.

The fact that some buyers have emerged is good news, as it says to us the logjam in this asset base shows some signs of loosening.

Look for Citigroup (C), Meryl Lynch (MER), Morgan Stanley (MS) and Wachovia (WB) to begin talking about a similar action. For shareholders, restoring the balance sheet in this manner is preferable to a large dilution on unfavorable terms, like the ones we have been seeing lately.

Disclosure: Long C, WB.

Comments

[SergeBirbrair]

Todd, UBS has more illiquid assets besides subprime mortgages.

What about illiquid ARS they have in their own acounts?

What about ARS they are about to purchase for their mutual funds?
www.nothingcontroversi...

[vnewspaper]

You mean UBS is going to show the banks more crooked ways of screwing people over. They have more bad assets than you can shake a stick out...now with some fancy accounting they are going to tie the garbage to a barge and let it float out to the ocean to be forgotten...which is pretty much what we do with garbage anyway in this world. It's one of those ugly things no one wants to acknowledge but UBS will have it's day of reckoning.

[ItsJustMe]

Todd, there is no magic pill to get bad assets off your balance sheet to "preserve capital." Whether you spin them off or sell them, the resulting writedown is going to wipe out your capital and you will be forced to either go bankrupt or raise additional capital to keep operating. UBS is raising additional capital now and they'll likely have to do it again this year.

ALL of the investment banks will have to raise additional capital this year in order to stay solvent. It doesn't matter if they spin their bad loans into a separate company, sell them off one by one or build a pretty wrought iron fence around them on their balance sheet.

A bad loan is a direct charge against a bank's capital no matter what type of accounting wrapping you put on it...

[ItsJustMe]

A follow-up to my comment above. As a CPA, what seems common-sense to me about financial statements isn't always clear to non-accountants so I'll elaborate a little more on why UBS' spinoff strategy is just window dressing that won't change anything in terms of their capital problems.

Let's say I manage a bank which has $50 million in capital (owners equity) and $150 million in bad loans of which I think $50 million will eventually be totally noncollectable. If I admit to all the bad loans and write them all off, I'll have ZERO left in capital and a LOT of angry shareholders - and worse, frightened depositors.

However, let's say I take UBS' approach. I try to hedge and say that only $25 million is noncollectable so I write that off and spin the remaining $125 million of debt into a separate company. I'll now have $25 million in remaining capital and an asset on my balance sheet called "Investment in Garbage Subsidiary." (Okay, I'll probably name it something less honest to fool investors).

That investment asset will be on my books for $125 million, but guess what? When the auditors come in at year-end, they're going to audit the books of that subsidiary just as they audit my own books and they'll force the $25 million writedown in my subsidiary investment. I'm now left with ZERO capital and angry shareholders.

That is why UBS is out raising capital. The subsidiary idea is just window-dressing to get the garbage loans out of sight. No one is going to buy their new subsidiary for the same reason no one is lining up to buy their garbage loans now.

Don't be fooled by accounting tricks. The UBS spinoff is pretty meaningless...

[helplessobserver]

I think the CPA's analysis is correct. With loans leveraged to 30:1 there won't be enough fool's gold to prop up these balance sheets. UBS is a disaster waiting to happen.

[todd su]

its just...

if they sell chunks, they do not write if off, correct? if they "spin it", then they recognize the proceeds and get rid of the bad loans, right?

i am not a CPA but that seems logical... (not that logic and accounting are synonymous)

[sc1ttl]

nonesnes. All u have to do is repackage like they are with CLOs. Sll he CLO to either a private fund or mutual fund, have those salespeople sell it to the unsuspecting schmucks, and then another mutual fund buy shares of the mutual fund buying the CLOs. Just that simple. Everyon in the intial CLO gets their money and when tha asset is written down again the mutual fund bagholders take the loss.

[ItsJustMe]

No, you're still missing it Todd. Let's say Wilbur Ross in your article above, wants to buy my $150 million in sub-prime loans. As a sophisticated investor, he knows as well as I do what they're really worth.

He's going to pay me $100 million for them and I'll have to recognize the $50 million loss. I just exchanged a $150 million loan receivable asset for $100 million in cash. The $50 million difference will be a loss on my income statement which then flows through to reduce my owners equity (capital) to zero.

The exact same thing happens if I spin off the $150 million loan receivable to a subsidiary. Instead of a $150 million loan receivable on my balance sheet, I now have a $150 million "Investment in Subsidiary." At the conclusion of that spinoff, nothing has happened to my total assets or equity.

However, since I own 100% of that subsidiary, the accounting rules state that whatever happens to the subsidiary also happens to me. If the subsidiary sells those loans to Wilbur Ross for $100 million, it will take a $50 million loss to its capital and the accounting rules force me to show the $50 million loss on my own books as a writedown of my "Investment in Subsidiary" from $150 million to $100 million.

There is no way for the banks to get rid of these bad loans without recognizing the losses. The accounting rules do not allow you to play smoke and mirrors with your financial statements by setting up subsidiaries. A bad loan is a bad loan and the only way you can get out of swallowing the loss is to either a) pretend it's not a bad loan and leave it on your books at full value which the banks have been doing, or b) sell it to a sucker who doesn't realize it's a bad loan.

Unfortunately, there aren't any suckers left which is why the large banks have reached desperation status. Quite frankly - and most people are stunned by this - if the projections of $1 trillion of write-offs by the end of the recession are accurate, the entire US banking system is insolvent.

That means that the losses will ultimately be more than the capital of ALL our banks combined. That doesn't mean that every single US bank is insolvent, but it does mean that the ones who are holding all of these NINJA and liar loans have significant negative equity.

That is why they are racing to raise capital. That is why Bernanke is making Fed moves unprecedented since the Great Depression. It's also why Bernanke looks scared to death and the politicians are asking what they can do to help rather than grilling him for risking billions of dollars of taxpayer money.

This is a VERY serious crisis and if the US banks start setting up subsidiaries, it is probably the prelude to a government takeover of those subsidiaries (at pennies on the dollar) rather than a means to get out of swallowing the losses...

[ItsJustMe]

scittl, your plan depends on ultimately selling the loans for 100% of full value to "unsuspecting schmucks." That worked from 2002 through 2007. There aren't any unsuspecting schmucks now and even if there were, it's not worth the certain lawsuits that are going to come from even the earlier unsuspecting schmucks...

[Voice ofReason]

As a past AUDITOR (I'm now retired) I have one word for all you wannabe accountants. Enron.

For years Kenny Boy and a few other guys with sharp pencils at Enron pulled the wool over the eyes of almost everybody... including regulators and the auditors from Aurthur Andersen that signed off on the financial statements and NEVER followed through where all the money was suppose to be coming from. It was just a shell game.

Either they knew what was going on and looking the other way or they bought the flim flam meaning they were just plain stupid, lazy or both (my choice).

Right now too many are writing down perfectly good paper just because a small portion is bad. Its the old throw the baby out with the wash water panic.

While I don't have figures handy I think I read the total subprime loan balance is multiple trillion. To suggest most of that is bad is a fairy tale and would make the 1929 stock market crash look like a picnic.

The feds did what they did with Bears exactly to avoid panic and start a run on all the banks. The big sharks on swimming around because they smell blood in the water. As usual Joe know nothing plays right into their hands and helps them drive down the stock prices so the big fish can grab it at fire sales prices. THAT is what the Feds should look into. Its just another varation on insider trading. I thought that was suppose to illegal. Don't even get me started on short selling or hedge funds.

[ItsJustMe]

VoR, I was an auditor for over 10 years (currently a no longer practicing CPA). Like most CPAs, I'm well aware of Enron and their cozy relationship with their auditor. It brought down an entire multi-national accounting firm so getting another auditor to turn his/her head to a shell game is not likely in today's environment.

The total estimated writedown of sub-prime loans is $460 billion. That number comes from Goldman Sachs which one would think would have no incentive to drive down their own stock price.

The total estimated writedown of ALL consumer and commercial debt assuming a recession (which is no longer an assumption) is around $1 trillion. The banks are NOT writing down perfectly good paper to zero. They use sophisticated mathematical models based on the current default rate of a group of mortgages to project the future default rate and their writedown is based on that.

I agree with you that the Fed acted to avoid a panic. It was a good move on their part. I disagree that "Joe" is playing into anyone's hands by selling his stock. Joe NEEDS to sell his investment bank stock. The banks and hedge funds have been shorting their own stock (along with homebuilders) for a year now because they knew the housing bubble was collapsing.

That is why you're seeing investment bank and homebuilders surging now because the banks and hedge funds are having to buy that stock back to close out their positions and raise cash. As soon as their positions are closed and their buying has ended, it won't be pretty...

[PJ568]

It works if they move "quality" illiquid assets and take it public, it can't be just a dumping ground for "toxic waste". Newco must have the ability to hold to maturity (concerned with credit not market risk), make sure they receive the current illiquidity discounts in place. Maybe its formed to receive assets from three or more banks. Newco has to be the real deal, capable of turning profits.

It benefits the banks by receiving cash (the IPO) and not further depressing prices by flooding the market with additional selling pressure. If they expect continued illiquidity for the next several years, they also avoid future write downs.

If they're thinking long-term, it could work for both the banks and the Newcos.

[ItsJustMe]

PJ568, you're still dealing with market value however. Yes, spinning it off to a new company and selling that company to the general public will get it off their books. That will solve their liquidity problem but not their solvency problem. They will still absorb the exact same loss which is where people are getting confused.

If my $150 million of mortgage loans have a probable write-down of $50 million, then my IPO is only going to bring in $100 million unless you're assuming the public is a bunch of uninformed fools. In 2007, they (we) probably were. In 2008, we're not.

With all the horrible publicity they're getting, their IPO would probably be a disaster and bring in even less than the mortgages are really worth which is why the government will end up buying these bad mortgages.

Then at some point down the road, when workouts have been determined and the bad publicity has settled down, I agree that Newco could go public as a long-term mortgage company...

[todd su]

itsjust,

i get that. my point is that by doing it that way they do eliminate future writedowns and have the "kitchen sink" event everyone is waiting for. at least in this way, investors can move forward with more clarity as to what the value of what is left is

[PJ568]

Itsjustme,

Agree that the article doesn't work by itself.

If you obtain liquidity and liquidity is 80% of solvency. If you can limit ongoing losses, rely on current profit producing areas, you've increased your ability to sell the preferred you have to issue.

[who]

Simply putting bad apples into another bucket does not mean they are not there.