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 other 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.
- 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
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 2 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-remote special purpose vehicle (SPV) or entity, which means that it is a separate business entity and is not rolled up into the sponsoring company's balance 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 large commercial banks or other asset managers such as investment banks or hedge funds. They issue asset-backed commercial paper (ABCP) as a way to fund purchases of investment grade securities 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 AAA and AA assets, which include an allocation to residential mortgage-backed securities. In contrast to a multi-seller or securities arbitrage conduit, an SIV does not employ credit enhancement, and the underlying SIV assets are marked-to-market at least weekly.
SIV sponsors may not be specifically liable for the performance of the ABCP issued, but may suffer reputational risk if 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 Structured Investment Vehicles 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 leverage of 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 more risky and their leverage amount increased. By 2004, 18 SIVs were managing $147 billion. In the subprime mortgage mania, this amount jumped to $395 billion by 2008.
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 its activities do not have an impact on the assets and liabilities of the bank that creates it. 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 by the end of 2008.
Example of Special Investment Vehicle
IKB Deutsche Industriebank is a German bank that lent 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 a bankruptcy, if it had not been rescued by an eight billion euro credit facility from KFW, a German state bank.