SIV

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A structured investment vehicle (SIV) was a type of fund in the shadow banking system. Invented by Citigroup in 1988, SIV's were popular until the market crash of 2008[1].

The strategy of these funds was to borrow money by issuing short-term securities at low interest and then lend that money by buying long-term securities at higher interest, making a profit for investors from the difference. SIVs were a type of structured credit product; they were often from $1bn to $30bn in size and invested in a range of asset-backed securities, as well as some financial corporate bonds.

SIVs had an open-ended (or evergreen) structure; they planned to stay in business indefinitely by buying new assets as the old ones matured, with the SIV manager allowed to exchange investments without providing investors transparency or the ability to look through the structure. As of October 2008, no SIVs remained going concerns.[2]

See also shadow banking.

Contents

Overview of SIVs

A SIV may be thought of as a virtual bank. Instead of gathering deposits from public, it borrows money by selling short maturity (often less than a year) commercial paper (CP) in the money market.

The interest rate charged is usually close to the LIBOR, that is the rate at which each bank lends money to other banks. It then uses the gathered funds to purchase long term (longer than a year) bonds with higher interest. An SIV would typically earn around 0.25% more on the bonds than it pays on the CP. This difference represents the profit that the SIV will pay to the capital note holders and the investment manager.

From the Financial Times, July 7, 2009

"Almost all the $400bn of assets held in structured investment vehicles have now been disposed of, two years on from their starring role in the early days of the financial crisis.

SIVs were early victims of the crisis when their style of financing illiquid long-term assets with short-term borrowing fell victim to the 2007 market crunch.

The attraction to investors had been the profits generated by the difference between cheap short-term funding and the income from higher-yielding but illiquid long-term holdings, including subprime mortgages. Once these benefits disappeared in the market convulsions, banks and other other SIV sponsors scrambled to rescue the vehicles.

Analysts at Fitch Ratings calculate that 95 per cent of the assets held in SIVs at the July 2007 peak have now been disposed of as the vehicles have been wound down – with much pain to investors, but without the wild market dislocation many feared.

Glenn Moore, of Fitch’s European structured credit team, said: “Although substantial, the asset disposals have been relatively orderly over the past two years. As the oversupply of assets from the SIV sector is removed, this is one less factor weighing on structured finance valuations.”

Of the 29 SIVs, five have been restructured, 13 were consolidated onto the sponsoring bank’s balance sheets and seven defaulted on payments of their senior borrowings. Fitch estimates just four have unwound themselves, at least one of which did so without losses to senior investors."

Structure of SIVs

The short-term securities that a SIV issues often contain two tiers of liabilities, junior and senior, with a leverage ratio ranging from 10 to 15.

The senior debt is invariably rated AAA/Aaa/AAA and A-1+/P-1/F1 (usually by two rating agencies). The junior debt may or may not be rated, but when rated it is usually in the BBB area. There may be a mezzanine tranche rated A.

The senior debt is a pari passu combination of medium-term notes (MTN) and commercial paper (CP). The junior debt traditionally comprises puttable, rolling 10-year bonds, but shorter maturities and bullet notes became more common.

In order to support their high senior ratings, SIVs are also obliged to obtain liquidity facilities (so-called back-stop facilities) from banks to cover some of the senior issuance. This helps to reduce investor exposure to market disruptions that might prevent the SIV from refinancing its CP debt. To the extent that the SIV invests in fixed assets, it hedges against interest-rate risk.

There are number of crucial difference between SIV and traditional banking. The type of financial service provided by traditional deposit banks is called intermediation, that is the banks become intermediate (middlemen) between primary lenders (depositor) and primary borrowers (individual, small to medium size business, mortgage holder, overdraft, credit card, etc). SIVs do exactly the same, "in effect", providing funds for mortgages, credit cards, student loans through securitised bonds.

In more traditional deposit banking, bank deposits are often guaranteed by the government. Moreover, for ordinary depositors, there is no other alternative to deposit their cash aside from putting their money under the carpet. Therefore, even if some depositor might withdraw money from one particular bank, they will simply transfer the money to another bank. Consequently, the availability of cash for deposit in totality does not change much. Moreover, each small individual depositor has little influence over setting the deposit interest rate. Therefore, the availability of deposits/funds in traditional banking is generally stable, which is why traditional banks can borrow largely in the form of on-demand deposit from the public and conduct lending on a long term basis.

On the other hand, the money market for CP is far more volatile. There are no government guarantees for these products in case of default, and both sellers and lenders have equal power at setting the rate. This explains why the borrowing side of SIV consists of fixed term rather than on-demand borrowing; however, in extreme circumstances like the 2008 credit crunch, the worried buyers, facing liquidity worries, might buy more secure bonds such as government bonds or simply put money in bank deposits instead and refuse to buy CP. If this happens, facing maturity of short term CP which was sold previously, SIV might be forced to sell their assets to pay off the debts. If the price of asset in depressed market is not adequate to cover the debt, SIV will default.

On lending side, traditional deposit banks directly deal with borrowers who seek business loans, mortgages, students loans, credit cards, overdrafts, etc. Each loan's credit risk are individually assessed and reviewed periodically. More crucially, the bank manager often maintains personal oversight over these borrowers. In contrast, SIV lending is conducted through the process known as securitization.

Instead of assessing individual credit risk, loans (for example, mortgage or credit card) are bundled with thousands (or tens of thousands or more) of the same type of loans. According to the law of large numbers, bundling of loans creates statistical predictability.

Credit rating agencies then allocate each bundle of loans into several risk categories and provide statistical risk assessment for each bundle in similar manner to how insurance companies assign risk. At this point, the bundle of small loans is transformed into a financial commodity and traded on the money market as if it were a share or bond. The bonds usually selected by a SIV are predominantly (70-80%) Aaa/AAA rated asset-backed securities (ABS) and mortgage-backed securities (MBS).

SIV lights

Source: From Risk Special Reports, May 2006

"The market for structured investment vehicles (SIVs) has matured steadily over the past few years, to the extent that what was once a niche credit area now accounts for a major part of the structured finance arena. The latest development is a tweaking of the SIV idea to form SIV-Lites - a combination of collateralised debt obligation (CDO) and SIV technologies.

So far, very few dealers have launched SIV-Lites. Barclays Capital led the way when it arranged and underwrote Golden Key for Geneva-based investment firm Avendis in November. Other alternative investment managers active in hedge funds and CDOs are also now looking at the structure. London-based Cairn Capital turned to Barclays to arrange and underwrite its SIV-Lite, Cairn High Grade Funding, in January. Barclays is also working with London-based Solent Capital, a specialist credit manager active in hedge funds and CDOs, to launch an SIV-Lite. However, while there are whispers that other houses are working on these vehicles, no other SIV-Lites have hit the market to date.

So what is driving this development? Edward Cahill, European head of CDOs at Barclays Capital in London, says his desk is focusing on SIV-Lites because traditional SIVs are not as profitable as they used to be. "The reality of the market is that spreads have tightened, so traditional SIV structures, with a very thick 10% BBB tranche and then commercial paper (CP) above it, don't work. I think it would be very difficult to start an SIV from scratch right now," he says.

Douglas Long, London-based product marketing manager at Principia Partners, a provider of structured finance processing technology, adds: "This is being driven by regulatory pressures, by tightening spreads and by general convergence and cross-pollenisation of techniques in the market - where people can see they can actually adopt SIV techniques within a CDO context."

Problems of SIVs

The risk that arises from the transaction is twofold. First, the solvency of the SIV may be at risk if the value of the long-term security that the SIV has bought falls below that of the short-term securities that the SIV has sold. Second, there is a liquidity risk, as the SIV borrows short term and invests long term; i.e., outpayments become due before the inpayments are due. Unless the borrower can refinance short-term at favorable rates, he may be forced to sell the asset into a depressed market.

When a traditional deposit bank provide loans such as business lending, mortgage, overdraft or credit card, they are stuck with the borrowers for years or even decades. Therefore, they have incentive to assess the borrowers' credit risk and further monitor the borrowers finance through their branch managers. In securitised loan, those who originate loan can immediately sell off the loan to SIV and other institutional investors and these buyers of securitised loans are the one who are stuck with credit risk.

Therefore, in SIV intermediation, there is significantly lower incentive to assess credit risk of borrowers at the point of loan origination. Rather, loan originators' reward is structured so that more loan they make and sell it wholesale, more commission they earn. Further, there was no incentive for them to monitor their clients' credit risk. These monitoring was supposedly substituted by rating agencies, which, rather than checking the financial state of individual clients, monitor the statistical performance of the bundled loan in totality to adjust their mathematical model.

Unsurprisingly, it turned out that credit risk assessment conducted by these form of lending were far more inadequate than the traditional lending done by deposit bank. Some mortgage loans even turned up to be liar's loans with some borrower essentially being NINJA (No Income No Job No Assets).

In traditional banking, when a downturn occurred, branch managers could individually review clients' financial condition, separate good borrowers from bad ones and provide individually tailored adjustments.

SIVs, on the other hand, are staffed by investment managers, who cannot assess the individual content of securitized/bundled loans, and instead rely entirely on the risk assessment provided by the credit rating agencies. This weakness was exposed when it turned out that complicated mathematical models, which is used to rate securitized loan, made fundamental assumptions that turned out to be wrong. The most significant among these assumptions were the trends in U.S. housing prices which declined far faster and deeper than statistical model predicted.

These complex statistical analyses were supposed to function as a good substitute for risk monitoring provided by individual branch bank managers. Had the model been correct, these inadequately assessed loans would have been rated as high risk resulting in a lower price for the bond.

However, when housing prices were constantly increasing, borrowers with inadequate income could cover mortgage repayments by borrowing further money against increased value of their house. This somewhat fictitious good payment record, which may be obvious if it was monitored by a bank manager, fed into the mathematical model of rating agencies whose weakness was exposed when the housing market start to tank.

The credibility of credit assessment provided by rating agencies was further eroded when it was revealed that they took a cut in the sales of securitised bonds which they themselves rated. When the entire spectrum of bundled loans from sub prime to premium AAA start to under-perform against statistical expectations, the valuation of assets held by SIVs became suspect. SIVs suddenly found it difficult to sell commercial paper while their previously sold commercial paper neared maturity. Moreover, their supposedly prime rated assets could be sold only at a heavy discount. In effect, this was a run on the bank.

Though the assumption of ever increasing housing prices was the fundamental problem, there were other mathematical / statistical problems too. This is particularly important to prevent such things from happening again. There was an error in estimating the aggregate probability of default from components as the interaction effects could not be estimated with similar accuracy as the independent effect. For example if an SIV had mortgage as well as auto loans the probability of default in the mortgage part or auto part could be estimated more accurately with the law of large numbers and past data with few assumptions like "the future will be similar to past". But to estimate the likelihood of mortgage default triggering defaults in auto loans is extremely difficult as past data points will miss that largely. So even if we assume some interaction effect was taken into consideration while pricing the SIV, it was far from accurate even mathematically from the beginning.

Senate hearing - off balance sheet vehicles, Sept. 18, '08

view archive webcast

The witnesses on Panel I will be:

  • Mr. Lawrence Smith, Board Member, Financial Accounting Standards Board (FASB);
  • Mr. John White, Director, Division of Corporation Finance, U.S. Securities and Exchange Commission; and
  • Mr. James Kroeker, Deputy Chief Accountant for Accounting, U.S. Securities and Exchange Commission.

The witnesses on Panel II will be:

  • Professor Joseph Mason, Hermann Moyse Jr. Endowed Chair of Banking, E.J. Ourso College of Business, Louisiana State University; *Mr. Donald Young, Managing Director, Young and Company LLC, and former FASB Board Member;
  • Ms. Elizabeth Mooney, Analyst, Capital Strategy Research, The Capital Group; and
  • Mr. George Miller, Executive Director, American Securitization Forum.

Six Senators ask SEC to improve off balance sheet disclosure

Senate Banking Committee member Robert Menendez (D-NJ) and 5 other Democratic senators have issued a letter, dated August 6, 2010, urging Securities and Exchange Commission (SEC) Chairwoman Mary Schapiro to require fuller and more accurate corporate accounting disclosure in filings made with the SEC. In the letter, Menendez and fellow Senators Edward Kaufman (D-DE), Carl Levin (D-MI), Diane Feinstein (D-CA), Barbara Boxer (D-CA) and Sherrod Brown (D-OH) request that the SEC employ existing rulemaking authority granted pursuant to the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) to require full disclosure of off-balance sheet activity.

The letter notes that, while the SEC did issue rules aimed at the disclosure of off-balance sheet activity pursuant to the Sarbanes-Oxley, the recent financial crisis was triggered, in part, by widespread off-balance sheet accounting arrangements which allowed large financial firms to hide trillions of dollars in obligations from investors, creditors, and regulators. The letter cites the fact that “Citigroup reportedly kept $1.1 trillion worth of assets off its books in various financing vehicles and trusts that were used to handle mortgage-backed securities and issue short-term debt” as an example of a public company failing to adequately disclose the risks posed by off-balance sheet arrangements to investors.

In the letter, Menendez and his colleagues call for the SEC to use its existing authority under Sarbanes-Oxley to require that the annual reports on Form 10-K filed with the SEC by public companies contain detailed disclosure regarding all the company’s off-balance sheet arrangements (not just those arrangements that are “reasonably likely” to affect the company’s financial condition, as is currently required). The letter also argues that companies should be required to explicitly justify why they have not included any off-balance sheet arrangements in their balance sheet. Additionally, the letter urges the SEC to encourage the Financial Accounting Standards Board (FASB) to improve financial reporting rules for all types of off-balance sheet activities and to monitor FASB’s efforts to prohibit off-balance sheet financing.


New off-balance sheet rule: Little impact on Wells

The new accounting standard requiring banks to bring assets back on balance sheet had a negligible impact on Wells Fargo. Despite having over $2.0 trillion of off-balance sheet assets, Wells consolidated just $10 billion of risk-weighted assets when the new standard took effect January 1. (See slide 17 in the bank’s supplemental earnings release)

The idea behind the new accounting standard is to bring hidden assets back into the light of day so that regulators can insure proper levels of capital are held against them. With Wells, this appears not to be happening.

Last summer, the bank estimated the new standard would raise risk-weighted assets by $46 billion.* In its last quarterly filing, it revised the estimate down to $25 billion.** When the standard finally went into effect, the figure was just $10 billion.

Total off balance sheet assets, meanwhile, were over $2.0 trillion at the end of September. (see page 31)

One reason for the giant difference is that “conforming” mortgages comprise a bit over half of Wells’ off balance sheet assets. These are eligible for a government guarantee via Fannie Mae, Freddie Mac, or Ginnie Mae, argues the bank, so they needn’t consolidate them since they pose no risk to its balance sheet.

Chris Whalen of Institutional Risk Analytics has argued this may be inappropriate. Some of these mortgages may be rejected by government guarantors — a more likely prospect it would seem with FHA beefing up standards. That could force Wells to take loan loss reserves against them.

A bigger question is the $900 billion worth of off-balance sheet assets that don’t qualify for a government guarantee. If indeed it’s fair for Wells to say it has so little exposure here, the bank should explain why to investors.

Ironically, the ultimate off balance sheet vehicles are the GSEs themselves: Fannie, Freddie and Ginnie Mae (which securitizes FHA loans). Though backed by taxpayers, the nearly $5.0 trillion worth of mortgages they guarantee aren’t included on Uncle Sam’s balance sheet.

With mortgage lending almost wholly dependent on GSE guarantees at this point, more of the nation’s housing stock disappears off-balance sheet every day…

FDIC delays brings SIV back on bank balance sheets

"Banks were saved in March when mark to market rules were overturned. Now another occurrence of "magic powder dispersion" is saving them again. An article by Silla Brush at The Hill.com (here) describes an announcement Friday (December 18) by the FDIC (Federal Deposit Insurance Corporation) that banks can delay up to one year the implementation of a new accounting rule from the FASB (Financial Accounting Standards Board) that will force the end to a manipulation banks have been using to hide risky assets.

The ruse that has been used involves what are called SIVs (Special Investment Vehicles) that are high risk assets the banks place off the balance sheet. The new rule, which takes affect January 1, 2010, requires all such assets be brought onto the banks' balance sheets. The FDIC announcement, in effect, delays the enforcement of the accounting practice in bank regulation and therefore allows banks to continue buying time to try to figure out how to deal with the stress of this "new honesty".

There may be up to a trillion dollars of SIVs that are affected. When these are brought under the rules of accounting, it is likely that many tens of billions of dollars of additional bank capital may be required for banks to maintain required capital ratios.

This is just another example of why I feel so insecure about the banks. I don't believe these SIVs were considered in the stress tests and they will eventually have an impact. It could have been in two weeks; now it may be in one year. If SIVs are still a problem, I am speculating the can will get kicked down the road and they will get two years. Or three? Or whatever it takes?

How can the financial engine ever run properly if we keep pouring sand in the gas tank?

How long will it take to sort this out? The American Bankers Association has asked for three years. Do you think they would ask for any less than they feel is needed?

Protium is the financial equivalent of a cellar

"... These days, of course, the word “SIV” has become almost as taboo as the phrase “subprime securitisation”. Yet, as I perused this week’s announcement that Barclays plans to sell $12.3bn of credit assets to a “newly established fund” called Protium Finance – which will be independent but mostly financed by a loan from Barclays – it was hard to escape a twinge of déjà vu.

To be sure, the details of the Barclays plan differ in some crucial ways from the old SIVs-cum-cellars. One central sin that bedevilled the SIVs was that banks often used them for regulatory arbitrage. Another was a reliance on cheap, short-term financing – which disappeared, with disastrous consequences, when the crisis started in 2007.

However, as Barclays repeatedly stressed this week, Protium is not focused on regulatory arbitrage: those $12.3bn assets will stay on Barclays’ balance sheet for regulatory purposes, in the sense that the bank will be forced to make big capital provisions against a $12.6bn loan it is extending to Protium. Moreover, Protium is not exposed to the funding risk that blew up the SIVs, thanks to that monster loan.

But in another sense, there is an uneasy echo of the past. Most notably, by selling those $12.3bn assets to Protium, what Barclays is essentially doing is taking a pile of toxic items out of its front room (ie the balance sheet) and stuffing it into an entity that is not inside the house (the garage, or cellar).

After all, the fine print of the Barclays announcement makes it clear that while the British bank is going to count the Protium assets as being “on balance sheet” for regulatory purposes, it is removing the assets from the balance sheet in accounting terms, since Protium is legally “independent”, based in the Cayman Islands.

That means the bank will not need to report the mark-to-market value of those assets, or reveal the source of equity finance for Protium that supplements the Barclays loan. Nor will it need to control the pay of the people running Protium, since they do not count as Barclays staff.

Now, many bankers would argue that such ring-fencing is not just sensible, but inevitable in the current world. Putting these assets into a dedicated unit, after all, puts them under the control of an experienced management team.

It also makes the “front room” of Barclays look smarter, since it shields the main balance sheet from sudden fluctuations in the value of toxic assets – and clarifies for shareholders where those assets are. In many ways, that represents progress. After all, at many western banks it is still a mystery what is (or is not) happening to all those troubled credits, or who is (or is not) sorting them out.

Yet, in spite of all those benefits, the fact remains that Protium is still the financial equivalent of a cellar: namely a dark place that is outside public scrutiny, but implicitly linked to the main financial “house”. And that points to a crucial challenge which is now dogging regulators – and which goes well beyond Barclays itself.

For the really dirty secret that currently bedevils the whole financial reform debate is that the more that regulators force banks to clean up their “front rooms” (ie regulated activity), the greater the risk that activity will flee to unregulated corners of finance – if nothing else because financiers have little desire to subject their pay to public scrutiny.

In theory, regulators could prevent that outflow, if they were willing to clamp down on the unregulated world in a co-ordinated way. In practice, though, western leaders are finding it so tough to agree on how to reform the front rooms of finance that I seriously doubt they will have the energy to attack the cellars too.

Thus far, few banks have had the political chutzpah to exploit that situation too brazenly. Barclays, however, now appears to be blazing a trail of sorts – and I would hazard a bet that plenty more banks will be tempted to follow suit. So stand by to see more Protium-style deals emerge in the coming months. After all, financial cellars can come in numerous forms – and, it would seem, ever more weird names.

2007 subprime mortgage crisis

In 2007, the sub-prime crisis caused a widespread liquidity crunch in the CP market. Because SIVs rely on short-dated CP to fund longer-dated assets, they are frequently refinancing. In August, CP yield spreads widened to as much as 100bp (basis points), and by the start of September the market was almost completely illiquid. That showed how risk-averse CP investors had become even though SIVs contain minimal sub-prime exposure and as yet had suffered no losses through bad bonds. It's a matter of debate, however, whether this risk aversion was a matter of prudence or misunderstanding of the CP market.

Several SIVs—most notably Cheyne—have fallen victim to the liquidity crisis. Others are believed to be receiving support from their sponsoring banks. It is notable that even among "failed" SIVs there have still been no losses to CP investors.

In October 2007 the U.S. government announced that it would initiate (but not fund) a Super SIV bailout fund (also called Master Liquidity Enhancement Conduit). This plan was abandoned in December 2007. Instead, banks such as Citigroup announced they would rescue the SIVs they had sponsored and would bring them onto the banks' balance sheets.

On Feb. 11, 2008, Standard Chartered Bank reversed its pledge to support the Whistlejacket SIV. Deloitte & Touche announced that it had been appointed receiver for the failing fund.

Developments in 2008

On Jan. 14, 2008, SIV Victoria Finance defaulted on its maturing CP. Standard & Poor's downrated debt to "D".

Bank of America's fourth-quarter 2007 earnings fell 95% due to SIV investments.[3]

SunTrust Banks earnings fell 98% during the same quarter.[4]

Northern Rock, which in August 2007 became the first UK bank to have substantial problems stemming from SIVs, was nationalized by the British government in February 2008. At the same time, U.S. banks began borrowing extensively from the Term Auction Facility (TAF), a special arrangement set up by the Federal Reserve Bank in December 2007 to help ease the credit crunch.

It is reported that the banks have borrowed nearly $50 billion of one-month funds collateralized by "garbage collateral nobody else wants to take" [5]

The Fed continued to conduct the TAF twice a month to ensure market liquidity. In February 2008, the Fed made an additional $200 billion available.

On October 2, 2008 the Financial Times reported that Sigma Finance, the last surviving and oldest of the SIV's has collapsed and entered liquidation. [6]

References

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