Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

UBS thought subprime was safer than Japanese Government Bonds

The Shareholder
Report on UBS Write-Downs
is very informative and interesting, but
what I found most striking was the fact that UBS started buying US
asset backed securities in 2002 because it thought that Japanese
Government Bonds were too risky. This switch took place in the
Relative Value Trading (RVT) portfolio used by central treasury to
manage the liquidity buffer for the entire UBS Group. This portfolio
was run by Foreign Exchange / Cash Collateral Trading (FX/CCT) within
the investment banking business of UBS. The report states:

UBS created the ABS Trading Portfolio in late 2002 / early 2003
after Credit Risk Control (“CRC”) downgraded its country
rating for Japan. This meant that FX/CCT had to reduce its then
substantial holding of Japanese Government Bonds
(“JGB”). Because FX/CCT retained the same level of funding
liabilities and an unchanged revenue budget, it proposed to build up a
portfolio of US ABS. In order for the assets to be a suitable
replacement for the holdings of JGB that were to be liquidated, any
replacement securities had to be:

  • REPO-able;
  • Highly rated – i.e. AA or AAA;
  • Capable of being pledged to (one or more of) the primary Central
    Banks as collateral for UBS’s own borrowings; and
  • Capable of being sold in the short term.

There were also a number of other advantages of ABS perceived at
the time, including small spreads, USD denomination and no interest
rate dependencies (floating rate instruments only in the
portfolio). Because they had a higher yield (e.g. than government
bonds), including ABS in the RVT Portfolio meant that there was no
negative carry trade in the RVT Portfolio.

This reminds me of the famous statement by Mirabeau during the
French Revolution: “I would rather have a mortgage on a garden
than a mortgage on a kingdom”. The fate of UBS’ subprime
assets has been only marginally better than that of Mirabeau’s


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