A structured investment vehicle (SIV) is a non-bank financial institution established to earn a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities it issues. They are simple credit spread lenders, frequently "lending" by investing in securitizations, but also by investing in corporate bonds and funding by issuing commercial paper and medium term notes, which were usually rated AAA until the 2008 financial crisis. They did not expose themselves to either interest rate or currency risk and typically held asset to maturity. SIVs differ from asset-backed securities and collateralized debt obligations in that they are permanently capitalized and have an active management team.
They are generally established as offshore companies and so avoid paying tax and escape the regulation that banks and finance companies are normally subject to. In addition, until changes in regulations around 2008, they could often be kept off the balance-sheet of the banks that set them up – like asset management activity – escaping even indirect restraints through regulation even though the sponsoring banks usually provided some level of guarantee to investors in the SIV. Due to their structure, the assets and liabilities of the SIV were more transparent than traditional banks for investors. SIVs were given the label by Standard & Poor's—Moody's called them "Limited Purpose Investment Companies" or "LiPICs". They are considered to be part of the non-bank financial system, which has two parts, the shadow banking system comprising the "bank sponsored" SIVs (which operated in the shadows of the bank sponsors' balance sheets) and the parallel banking system, made up from independent (i.e. non-bank-aligned) sponsors.
Invented by Citigroup in 1988, SIVs were large investors in securitization. Some SIVs had significant concentrations in US subprime mortgages, while other SIV had no exposure to these products that are so linked to the 2008 financial crisis. After a slow start (there were only seven SIVs before 2000) the SIV sector tripled in assets between 2004 and 2007, and at their peak in mid 2007, there were about 36 SIVs with assets under management in excess of $400 billion. By October 2008, no SIVs remained active.
The strategy of SIVs is the same as traditional credit spread banking. They raise capital and then lever that capital by issuing short-term securities, such as commercial paper and medium term notes and public bonds, at lower rates and then use that money to buy longer term securities at higher margins, earning the net credit spread for their investors. Long term assets could include, among other things, residential mortgage-backed security (RMBS), collateralized bond obligation, auto loans, student loans, credit cards securitizations, and bank and corporate bonds.
History In 1988 and 1989, two London bankers, Nicholas Sossidis and Stephen Partridge-Hicks launched the first two SIVs for Citigroup, called Alpha Finance Corp. and Beta Finance Corp. Alpha had a maximum leverage of 5 times its capital with each asset requiring 20% of capital irrespective of its credit quality. Beta had leverage of up to 10 times capital but leverage was based on risk weightings of the assets. In 1993, Sossidis and Partridge-Hicks left Citigroup to form their own management firm, Gordian Knot, located in London's Mayfair. "Alpha Finance was created in response to volatility in the capital markets at the time. Investors wanted a highly-rated vehicle that would yield more stable returns on their capital, said Henry Tabe, a managing director for Moody's Investors Service's London office."Donna Mitchell, SIV market grows, so do SIV-lites', 21 August 2006 Asset Securitization Rep. Henry Tabe provides further historical background in his book on how SIVs unravelled during the crisis and lessons that can be learned from the sector's extinction.The Unravelling of Structured Investment Vehicles: How Liquidity Leaked Through SIVs (Lessons in Risk Management and Regulatory Oversight), Thoth Capital, November 2010 leakingSIVs.com.
In 1999, Professor Frank Partnoy wrote, "certain types of so-called 'arbitrage vehicles' demonstrate that companies are purchasing credit ratings for something other than their informational value. One example is the credit arbitrage vehicle, also known as a Structured Investment Vehicle (SIV). A typical SIV is a company which seeks to 'arbitrage' credit by issuing debt or debt-like liabilities and purchasing debt or debt-like assets, and earning the credit spread differential between its assets and liabilities. Much of an SIV's portfolio may consist of asset-backed securities." However, Portnoy's quote is misleading, in reality there is no such "arbitrage", the SIV is acting like any old fashioned spread banker, seeking to earn a spread between its income on assets and cost of funds on liabilities. It earns this spread by accepting two types of risk: a credit transformation (lending to AA borrowers while issuing AAA liabilities) and a maturity transformation (borrowing short while lending long). The scale of both transformations were considerably less than traditional banks, and leverage was also typically half to a quarter of that used by banks, so the risks were less and the returns available were also much lower.
The introduction of Basel I regulations made holding bank capital and asset-backed securities (ABSs) expensive for a bank, depending on the ratings assigned by one of the Government sponsored ratings agencies. ABS's that were able to attain a rating of AA or AAA had capital requirements as low as 1.6% of the securities' size (8%x20%), allowing for higher leverage than would have been allowed otherwise. Bank capital securities, such as dated subordinated debt could be weighted as highly as to amount to a deduction from capital. That is to say all the investment would be funded from capital.
A 'loophole' in the Basel accords meant that banks could provide a liquidity facility to the SIV of up to 360 days without holding capital against it so long as it was undrawn. However these facilities typically represented only between 10% and 20% of the total balance sheet of the SIV.
Partnoy then questioned the economic theory of SIVs: "How is the SIV able to earn such an 'arbitrage' spread between its assets and liabilities? If the SIV is simply a vehicle for purchasing financial assets, it should not be able to fund purchases of those assets at a lower rate than the rate on those assets. If it could, market participants with low funding rates would simply purchase the financial assets directly, and capture the spread for themselves. Put more simply, if a vehicle purchases $100 million of asset-backed bonds, priced at par, with a coupon of seven percent, and it seeks to fund that purchase by borrowing $100 million, it should not be able to borrow at a rate lower than seven percent."
Portnoy's theory misses the simple fact that the SIVs raised capital from third party investors with which to enhance the liabilities so these were not simple pass-through structures. Those investors benefitted from the SIV raising funding on their behalf at lower rates than they could themselves due to the tight criteria required by the rating agencies.
Alpha's maximum leverage was five times. Beta's leverage was up to 10 times, depending upon the quality of its asset portfolio. Subsequent SIVs, such as Centauri and Dorada, raised the leverage to around 20 times. Typically banks are leveraged between 25 and 50 times, so most SIVs operated with leverage of approx half that of traditional banks. By 2004, Sedna was offering notes that were leveraged over 100 times that attempted to achieve a spread of 10% or more in the medium term.1 October 2004 Banker: Capital Markets: Team of the Month - Citigroup SIV Enters Uncharted Space - Citigroup Alternative Investments Last Month Launched A Pioneering Structured Investment Vehicle. It Boosts Leverage to the Subordinated Noteholder Without Really Increasing The R
At the end of 2004, there were 18 operational SIVs that managed assets then valued at a total of $147 billion.1 July 2005 Structured Finance International 28, Breathing in: tight asset spreads make life tough for SIV managers, but if spreads widen the sector should grow dramatically. Chris Dammers looks at how managers are coping in the current environment, and talks to the new entrants At the end of 2005, according to Standard & Poor's, SIVs represented more than $200 billion of assets under management.
As of September 2007, one paper reported: "All SIVs to date have been established in either the Cayman Islands or Jersey so as to benefit from certain zero-tax regimes available in those jurisdictions. As mentioned, the SIV will usually also establish a subsidiary in Delaware to facilitate the issuance of debt in the US domestic market. The debt issued in the US will either be guaranteed by the offshore parent, or co-issued by the SIV and the subsidiary."Id.
Overview A SIV may be thought of as a very simple virtual non-bank financial institution (i.e. it does not accept deposits). Instead of gathering deposits from the public, it borrows cash from the money market by selling short maturity (often less than a year) instruments called commercial paper (CP), medium term notes (MTNs) and public bonds to professional investors. SIVs had the highest ratings of AAA/Aaa, as a result of their very high quality portfolio requirements, almost zero exposure to interest rate and FX risk and large capital base (compared to traditional banks). This enabled them to borrow at interest rates close to the LIBOR, the rate at which banks lend to each other. The gathered funds are then used to purchase long term (longer than a year) bonds with credit ratings of between AAA and BBB. These assets earned higher interest rates, typically 0.25% to 0.50% higher than the cost of funding. The difference in interest rates represents the profit that the SIV pays to the capital note holders part of which return is shared with the investment manager.
Structure 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 times. 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 were obliged to obtain significant capital and 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 rate 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 mortgage loans, credit cards, student loans through securitised bonds.
In more traditional deposit banking, bank deposits are often guaranteed by the government. Regulators assume that deposits are stable as a consequence.