In UBS (UBS) Break-Up, A Lesson For Merrill Lynch (MER) and Citigroup (C)

No one has really worked out how to wall-off significant risk in one division of a financial services giant from divisions which are "safe" and operating smoothly.

UBS (UBS) skinned its investors alive again by posting a $329 million loss on another $5.1 billion in write-downs. The bank made it clear that these troubles came from its investment bank and that its wealth management business was secure. That has not mattered to worried clients who do business with the healthy part of the company. They want out of any risk the institution might have.

UBS did what many companies do when merging pieces together has not worked. They are pulling the pieces apart. According to The Wall Street Journal, UBS "said it will begin separating its troubled investment bank from its money-management arm for the wealthy." The ship many be sinking, but at least the crew can save the women and children.

While the move is not exactly a "good bank, bad bank" strategy like the one used by some financial companies in the US three decades ago, it does wall-off the healthy part of the company.

Several US firms have a problem almost identical to the one at UBS. JP Morgan (JPM), considered one of the better run American banks, said it had lost $1.5 billion in July due to falling values in mortgage-backed paper. If JP Morgan is still having these troubles it is easy to imagine that they are worse at more troubled firms including Merrill Lynch (MER), Citigroup (C), and Wachovia (WB).

There has been a great deal of talk about breaking Citigroup into pieces. The primary reason behind this is that it would make it easier for the conglomerate to sell off divisions to raise money. But, now there is a more compelling reason. Money held by private clients can be segregated from the parts of the bank which are mired in an asset sewage. The concerns of consumer customers can be assuaged by cutting off the troubled part of the company.

Merrill Lynch, Citigroup, and Wachovia will almost certainly be faced with more very large write-offs and the need to raise more capital. That capital and the dilution that goes with it should sit where they belong in the investment banking divisions of the companies. Both consumer clients and shareholders should have the chance of being associated with the part of the firms that will almost certainly do well.

Douglas A. McIntyre