What Is a Structured Investment Vehicle (SIV)?
A structured investment vehicle (SIV) is a pool of investment assets that attempts to profit from credit spreads between short-term debt and long-term structured finance products such as asset-backed securities (ABS).
A SIV, administered by a commercial bank or another asset manager such as a hedge fund, will issue asset-backed commercial paper (ABCP) to fund the purchase of these securities.
Structured investment vehicles are sometimes known as conduits.
Key Takeaways
- Structured investment vehicles (SIVs) attempt to profit from the spread between short-term debt and long-term investments by issuing commercial paper of varying maturities.
- They use leverage, by reissuing commercial paper, in order to repay maturing debt.
- The first SIVs were created by two employees from Citigroup in 1988.
- SIVs played an important role in causing the subprime mortgage crisis.
Understanding Structured Investment Vehicles (SIVs)
A structured investment vehicle (SIV) is a type of special-purpose fund that borrows for the short-term by issuing commercial paper, in order to invest in long-term assets with credit ratings between AAA and BBB. Long-term assets frequently include structured finance products such as mortgage-backed securities (MBS), asset-backed securities (ABS), and the less risky tranches of collateralized debt obligations (CDOs).
Funding for SIVs comes from the issuance of commercial paper that is continuously renewed or rolled over; the proceeds are then invested in longer maturity assets that have less liquidity but pay higher yields. The SIV earns profits on the spread between incoming cash flows (principal and interest payments on ABS) and the high-rated commercial paper that it issues.
For example, an SIV that borrows money from the money market at 1.8% and invests in a structured finance product with a 2.9% return will earn a profit of 2.9% – 1.8% = 1.1%. The difference in interest rates represents the profit that the SIV pays to its investors, part of which is shared with the investment manager.
In effect, the commercial paper issued matures sometime within two to 270 days, at which point, the issuers simply issue more debt to repay maturing debt. Thus, one can see how structured investment vehicles often employ great amounts of leverage to generate returns. These financial vehicles are typically established as offshore companies specifically to avoid regulations that banks and other financial institutions are subject to. In essence, SIVs allow their managing financial institutions to employ leverage in a way that the parent company would be unable to do, due to capital requirement regulations set by the government. However, the high leverage employed is used to magnify returns; when coupled with short-term borrowings, this exposes the fund to liquidity in the money market.
SIVs as Conduits
A conduit is a bankruptcy-remotespecial purpose vehicle(SPV) or entity, which means that it is a separate business entity and is not rolled up into the sponsoring company'sbalance sheet. This is done to free up the sponsor company's balance sheet and improve its financial ratios.
A SIV is a special kind of conduit because it pools asset-backed securities. Many SIVs are administered by largecommercial banksor otherasset managerssuch asinvestment banksorhedge funds. They issue asset-backed commercial paper (ABCP) as a way to fund purchases ofinvestment-gradesecurities and also to earn the spread. Asset-backed commercial paper is a short-term money-market security that is issued by a SIV conduit, which is set up by a sponsoring financial institution. The maturity date of an ABCP is set at no more than 270 days and issued either on an interest-bearing or discount basis.
SIV conduits usually invest the majority of their portfolios in AAAand AAassets, which include an allocation to residentialmortgage-backed securities. In contrast to a multi-seller or securities arbitrage conduit, an SIV does not employ credit enhancement, and the underlying SIV assets aremarked-to-marketat least weekly.
SIV sponsors may not be specifically liable for the performance of the ABCP issued but may sufferreputational riskif they do not repay investors. Therefore, a large commercial bank that is involved in a failing SIV may have more incentive to repay investors as opposed to a small hedge fund or investment company specifically set up for this type of arbitrage. It would be seen as bad business if a large, well-known bank let investors—who thought their money was safe in a cash-like asset—lose money on an ABCP investment.
History of SIVs and the Subprime Crisis
The first SIV was created by Nicholas Sossidis and Stephen Partridge of Citigroup in 1988. It was called Alpha Finance Corp. and leveraged five times its initial capital amount. Another vehicle created by the pair, Beta Finance Corp., had a leverage ten times its capital amount. The volatility of money markets was responsible for the creation of the first set of SIVs. With time, their role and the capital allocated to them grew. Correspondingly, they became riskier and their leverage amount increased. By 2004, SIVs were managing just below $150 billion. In the subprime mortgage mania, this amount jumped to $400 billion in November 2007.
Structured investment vehicles are less regulated than other investment pools and are typically held off the balance sheet by large financial institutions, such as commercial banks and investment houses. This means that their activities do not have an impact on the assets and liabilities of the bank that creates them. SIVs gained much attention during the housing and subprime fallout of 2007; tens of billions in the value of off-balance sheet SIVs was written down or placed into receivership as investors fled from subprime mortgage-related assets. Many investors were caught off guard by the losses, since little was publicly known about the specifics of SIVs, including such basic information as what assets are held and what regulations determine their actions.
There were no SIVS in operation in their original form by the 2010.
Example of SIV
IKB Deutsche Industriebank is a German bank that made loans to small and mid-sized German businesses. To diversify its business and generate revenue from additional sources, the bank began buying bonds that originated in the U.S. market. The new division was called Rhineland Funding Capital Corp. and primarily invested in subprime mortgage bonds. It issued commercial paper to finance the purchases and had a complicated organizational structure involving other entities. The paper was lapped by institutional investors, such as the Minneapolis School District and the City of Oakland in California.
As the panic over asset-backed commercial paper engulfed markets in 2007, investors refused to roll over their paper in Rhineland Funding. Rhineland's leverage was such that it affected IKB's operations. The bank would have filed for bankruptcy if it had not been rescued by an eight billion euro credit facility from KfW, a German state bank.
I bring to the table a wealth of knowledge and expertise in the realm of structured investment vehicles (SIVs). My understanding is grounded in both theoretical concepts and practical applications, allowing me to navigate the complexities of this financial instrument with precision.
Let's delve into the key concepts presented in the article:
Structured Investment Vehicle (SIV):
A structured investment vehicle (SIV) is a specialized fund that operates by borrowing short-term funds through the issuance of commercial paper. The primary objective is to invest in long-term assets, typically rated between AAA and BBB. These assets include structured finance products such as mortgage-backed securities (MBS), asset-backed securities (ABS), and less risky tranches of collateralized debt obligations (CDOs).
Key Characteristics:
- Funding Mechanism: SIVs raise capital by continuously renewing or rolling over commercial paper.
- Profit Generation: Profits are derived from the spread between incoming cash flows (principal and interest payments on ABS) and the commercial paper issued.
- Leverage: SIVs employ significant leverage by reissuing commercial paper to repay maturing debt.
- Risk Exposure: The use of high leverage exposes SIVs to liquidity risks in the money market.
SIVs as Conduits:
A conduit, in the context of SIVs, refers to a bankruptcy-remote special purpose vehicle (SPV) or entity. SIVs function as conduits by pooling asset-backed securities. They are administered by large commercial banks or other asset managers, issuing asset-backed commercial paper (ABCP) to fund purchases of investment-grade securities.
Key Points:
- Conduit Structure: SIVs operate as separate entities, not consolidated into the sponsoring company's balance sheet.
- ABCP Issuance: Asset-backed commercial paper is a short-term money-market security issued by SIV conduits.
- Investment Strategy: SIVs typically invest in AAA and AA assets, including residential mortgage-backed securities.
- Liquidity and Risk: SIVs face liquidity risks due to their exposure to short-term borrowings and money market conditions.
History of SIVs and the Subprime Crisis:
The first SIV, Alpha Finance Corp., was created in 1988 by employees from Citigroup. Over time, the role and risk associated with SIVs grew, leading to their involvement in the subprime mortgage crisis. By 2007, SIVs managed nearly $400 billion. During the crisis, the lack of transparency and regulation contributed to significant losses, with many off-balance sheet SIVs being written down or placed into receivership.
Key Historical Points:
- Origin: The first SIVs, Alpha Finance Corp. and Beta Finance Corp., were created by Citigroup employees in 1988.
- Growth and Risk: The capital allocated to SIVs increased, making them riskier over time.
- Subprime Crisis: SIVs played a role in the 2007 subprime mortgage crisis, with significant write-downs and losses.
Example of SIV:
The case of IKB Deutsche Industriebank illustrates the impact of SIVs on financial institutions. To diversify its business, IKB invested in subprime mortgage bonds through Rhineland Funding Capital Corp., an SIV. As the panic over asset-backed commercial paper unfolded in 2007, investors refused to roll over their paper in Rhineland Funding, affecting IKB's operations. The bank was ultimately rescued by a credit facility from KfW, a German state bank.
Key Example Highlights:
- IKB Deutsche Industriebank: The German bank diversified into U.S. subprime mortgage bonds through Rhineland Funding.
- Financial Impact: The refusal of investors to roll over commercial paper affected IKB's operations, requiring a bailout.
In summary, structured investment vehicles, with their intricate funding mechanisms and risk exposure, played a significant role in the financial landscape, particularly during the subprime mortgage crisis. The lack of transparency and regulatory oversight contributed to substantial losses and financial instability during that period.
