Too big to fail, a Swiss icon swings back to life

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In another country, UBS AG, Switzerland's flagship bank, would be dead or merged out of existence. The bank hit every land mine imaginable, from the U.S. subprime disaster to the legal assault on tax-dodging clients that, absent a settlement, could have crushed the life from its American business.

Yet the sorry beast has managed to survive the two-year siege. It is even attracting the attention of value investors again. Switzerland's Bank Sarasin just slapped a "buy" recommendation as analysts took the view that UBS's bruising at the hands of U.S. government could have been a lot worse.

"Our view is that with the agreement, one of the most threatening items for UBS on the way back to profitability falls away," says Sarasin analyst Daniel Bischof.

He thinks the contrite, overhauled, cleaned-up and slimmed-down bank will slowly emerge from legal and financial limbo to become a banking force once again. "It is our view that UBS will regain its operational strengths," he says.

He and other analysts credit UBS's near-miraculous survival in part to Swiss government protection, borne from the fear that the bank's collapse would destroy the Swiss economy. At one point, UBS's assets were four times the size of the country's GDP.

A dud UBS would also have clobbered the government's own investment portfolio. Until Thursday, the government owned 9 per cent of UBS, a stake it took last year when it bailed out the ailing bank.

Equally effective was the fear within the bank.

Fresh executives and directors, among them vice-chairman Sergio Marchionne, Fiat's Italian-Canadian CEO, blasted bodies out the door, shrank the high-risk businesses, cut costs with alacrity, and protected the wealth management and retail banking core.

In short, UBS was a Swiss icon whose failure was unthinkable because it was unaffordable.

The announcement of a deal Wednesday between the U.S. and Swiss governments removed the sword of Damocles over UBS's head. In a blow to Swiss bank secrecy, the Swiss government will hand over the names of suspected American tax dodgers who held 4,450 UBS accounts. The deal came six months after the bank eliminated the threat of criminal prosecution by agreeing to pay the U.S. government $780-million (U.S.) while admitting it had schemed to defraud the United States by helping Americans shield their money from the Internal Revenue Service.

But the news was not all bad for the bank. UBS was not hit with another penalty and, crucially, the U.S. government agreed to drop its lawsuit against the bank. The government will now pursue the tax information under a tax treaty between the two countries.

Suddenly, the prospect of recovery is tantalizingly within reach for UBS, unless, of course, the bank's fondness for land mines makes a comeback.

The beginning of UBS's fall goes back to March, 2006. That's when Bradley Birkenfeld, an American UBS employee, decided to blow the whistle on the UBS scheme to market Swiss accounts to wealthy Americans and then help disguise the accounts' ownership through the use of offshore shell corporations.

At the time, the bank - the product of the 1998 merger of Union Bank of Switzerland and Swiss Bank Corp. - was on top of the world. With automaton Swiss efficiency and determination, UBS had built the world's biggest wealth management business.

It had also used the purchases of Dillon Read, S.G. Warburg and PaineWebber, bought for $11.8-billion in 2000, to become a global force in investment banking and securities trading. The UBS trading floor in Stamford, Conn., was the size of three football fields and was listed as the world's largest trading floor by Guinness World Records .

The rapid-fire acquisitions apparently triggered a personality change within the staid old bank. While UBS's wealth management generated more than half of overall profits, investment banking came a close second, with 40 per cent of the profit. That was enormous by Wall Street standards - only about 5 per cent of Goldman Sachs's profits at the time came from investment banking.

As it was building its investment banking and trading businesses, UBS took its eye off the risk management ball and placed outsized bets. It funnelled more than $100-billion into U.S. asset-backed securities, many of the deadly subprime mortgage variety. The cancer first became apparent in August, 2007, when the bank issued a profit warning, one that came more than a year before Lehman Brothers' bankruptcy.

By the end of 2007, UBS probably had the highest leverage ration of any big banks, with assets amounting to an astounding 53 times total equity. By comparison, U.S. banks had an assets-to-equity ratio of about 20 before the stock market crash last autumn.

UBS was an accident waiting to happen. Between mid-2007 and the end of last year, the bank wrote off more than $40-billion of dud investments. Assets under management melted away. The outflows in the past two quarters alone came to about 80 billion Swiss francs (equivalent to about $75-billion).

As banks, investment banks and insurers everywhere collapsed, merged or were bailed out, UBS went into panic mode. It sold non-core assets, such as its investment in Bank of China, and housed $60-billion of illiquid assets with the Swiss national bank.

It took a flamethrower to the investment banking and executive ranks. Out went chairman Marcel Ospel, the architect of UBS's global expansion. The bank appointed a new CEO, Oswald Gruebel, in February, the same month it reported a 2008 loss of 19.7 billion francs, a record for a Swiss company.

Just as it looked like the worst was over for UBS, the tax evasion scandal blew wide open. In February, just after it made the $780-million payment to the U.S. government, the American tax authorities said they were pursuing a lawsuit seeking access to the banking details of 52,000 UBS clients.

UBS said it would go out of business if it complied, because revealing the clients' details would violate Swiss secrecy laws. The Swiss government came to the rescue again a month later, by agreeing to make concessions on bank secrecy. In July, the U.S. Justice Department said the U.S. government and UBS had reached an agreement in principle to settle the tax war. That agreement was revealed this week.

Thursday, the Swiss government got a payback, however small, for all its hard work in bailing out UBS and shielding it from a tax assault that had the potential to eradicate its U.S. presence. The Swiss government turned a profit of about $1.1-billion on the sale of its 9-per-cent stake, held through convertible notes bought last October.

The notes were converted into UBS shares and were four times oversubscribed - a good sign that investors think UBS, after two years of near-death experiences, is rising again.