What is a structured investment vehicle (SIV)?
A structured investment vehicle (SIV) is a pool of investment assets that attempts to take advantage of credit spreads between short-term debt and long-term structured finance products such as asset-backed securities ( ABS).
An SIV administered by a commercial bank or other asset manager such as a hedge fund, will issue asset-backed commercial paper (ABCP) to finance the purchase of such securities.
Structured investment vehicles are sometimes referred to as conduits.
Key points to remember
- Structured investment vehicles (SIVs) attempt to take advantage of the spread between short-term debt and long-term investments by issuing commercial paper with different maturities.
- They use leverage, by reissuing commercial paper, to pay off maturing debt.
- The first SIVs were created by two Citigroup employees in 1988.
- SIVs played an important role in the subprime 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 least risky tranches of secured debt securities (CDOs).
The financing of SIVs comes from the issuance of continuously renewed or renewed commercial paper; the proceeds are then invested in longer-dated assets that have less liquidity but offer higher returns. The SIV earns profits on the difference between the incoming cash flows (principal and interest on ABS) and the commercial paper 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 return of 2.9% will make a profit of 2.9% – 1.8% = 1.1%. The interest rate difference represents the profit that the SIV pays to its investors, part of which is shared with the investment manager.
This is because the commercial paper issued matures within two to 270 days, at which point issuers simply issue more debt to repay the debt as it matures. Thus, one can see how structured investment vehicles often use large amounts of leverage to generate returns. These financial vehicles are generally established as offshore companies specifically to avoid the regulations to which banks and other financial institutions are subject. Essentially, SIVs allow their managing financial institutions to use leverage in a way that the parent company would not be able to do, due to capital requirements regulations set by the government. However, the high leverage used is used to boost returns; coupled with short-term borrowings, it exposes the fund to liquidity on the money market.
SIV as conduits
A conduit is a vehicle or special purpose entity (SPV) in bankruptcy, which means that it is a separate business entity and is not included in the sponsoring company’s balance sheet. It is about freeing the balance sheet of the sponsoring company and improving its financial ratios.
A SIV is a special type of conduit because it groups together 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 means of financing the purchases of investment grade securities and also to gain the spread. Asset-backed commercial paper is a short-term money market security that is issued through an SIV conduit, which is arranged by a sponsoring financial institution. The maturity date of an ABCP is fixed at 270 days maximum and issued either with interest or with a discount.
SIV conduits typically invest the majority of their portfolios in AAA and AA assets, which include an allocation to residential mortgage-backed securities. Unlike a multi-seller or securities arbitrage conduit, an SIV does not use credit enhancement and the underlying assets of the SIV are marked-to-market at least once a week.
SIV sponsors may not be specifically responsible for the performance of the issued ABCP, but may incur reputational risk if they do not reimburse investors. Therefore, a large commercial bank involved in a failed SIV may have more incentive to reimburse investors than a small hedge fund or an investment firm specifically set up for this type of arbitrage. It would be considered a bad deal if a big well-known bank let investors–who thought their money was safe in a cash-like asset – are losing 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 has mobilized five times its initial capital. Another vehicle created by the pair, Beta Finance Corp., had a leverage of ten times its capital. The volatility of the money markets is at the origin of the creation of the first series of SIVs. Over time, their role and the capital allocated to them has increased. As a result, they became riskier and the amount of their leverage increased. In 2004, SIVs managed just under $ 150 billion. In the sub-prime mortgage craze, that amount jumped to $ 400 billion in November 2007.
Structured investment vehicles are less regulated than other investment pools and are typically held off-balance sheet by large financial institutions, such as commercial banks and investment firms. This means that its activities have no impact on the assets and liabilities of the bank that creates it. SIV received a lot of attention during the real estate and subprime fallout of 2007; tens of billions of off-balance sheet SIVs were written down or placed in receivership as investors fled subprime-related assets. Many investors were caught off guard by the losses as little was known to the public about the specifics of SIVs, including basic information such as assets held and the regulations that determine their actions.
There were no SIVS in operation in their original form in 2010.
Example of a special investment vehicle
IKB Deutsche Industriebank is a German bank which lent to German small and medium-sized enterprises. To diversify its business and generate income from additional sources, the bank started buying bonds from the US market. The new division was called Rhineland Funding Capital Corp. and invested primarily in subprime mortgage bonds. It issued commercial paper to finance purchases and had a complicated organizational structure involving other entities. The paper has been lapped by institutional investors, such as the Minneapolis School District and the City of Oakland in California.
As panic over asset-backed commercial paper engulfed markets in 2007, investors refused to renew their paper in Rhineland Funding. The influence of the Rhineland was such that it affected the operations of IKB. The bank would have filed for bankruptcy if it had not been rescued by an eight billion euro line of credit from KfW, a German state bank.