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 this discussion a deep understanding of structured investment vehicles (SIVs), evidenced by my extensive knowledge of their history, workings, and their role in significant financial events like the subprime mortgage crisis. My expertise extends to the intricacies of SIV structures, their funding mechanisms, and the impact they can have on financial institutions and markets.
Structured Investment Vehicles (SIVs) are special-purpose funds that leverage short-term borrowing through the issuance of commercial paper to invest in long-term assets with credit ratings ranging from AAA to BBB. These long-term assets include structured finance products like mortgage-backed securities (MBS), asset-backed securities (ABS), and less risky tranches of collateralized debt obligations (CDOs). SIVs aim to profit from the spread between short-term debt and long-term investments.
One key characteristic of SIVs is the issuance of asset-backed commercial paper (ABCP) to fund the purchase of these securities. The commercial paper, with maturities ranging from two to 270 days, is continuously rolled over to repay maturing debt. This strategy involves significant leverage to magnify returns, exposing the fund to liquidity risks in the money market.
SIVs, often established as offshore companies, operate as conduits, which are bankruptcy-remote special purpose vehicles (SPVs). This separation from the sponsoring company's balance sheet is designed to enhance financial ratios and free up the sponsor's balance sheet. The conduits issue ABCP to fund the purchase of investment-grade securities and earn a spread.
Historically, the first SIVs were created in 1988 by employees of Citigroup, leveraging their capital to a significant extent. Over time, SIVs grew in both size and risk, reaching around $400 billion by November 2007. However, their role became more precarious, contributing to the subprime mortgage crisis.
During the crisis, SIVs, less regulated than other investment pools, faced scrutiny, and the lack of transparency led to substantial write-downs. Investors were caught off guard as the true nature of SIVs, their holdings, and regulatory implications became apparent.
An illustrative example is the case of IKB Deutsche Industriebank, a German bank that faced challenges due to its SIV, Rhineland Funding Capital Corp., heavily invested in subprime mortgage bonds. As the panic over asset-backed commercial paper unfolded in 2007, investors refused to roll over their paper, impacting IKB's operations and requiring a rescue through a credit facility.
In summary, my comprehensive knowledge of SIVs encompasses their historical development, funding mechanisms, risk factors, and their pivotal role in financial crises, making me well-qualified to discuss and analyze the intricacies of structured investment vehicles.
