SIVs: Employing All the Abuses the Credit Bubble Made Famous

You have to hand it to the humble SIV (structured investment vehicle). To create one, you must employ just about all the abuses the credit bubble made famous.

SIVs had everything: regulatory arbitrage, opacity, reaching for yield, multiple opportunities for bankers to generate fee income, multiple layers of leverage, rating agency incompetence, credit default swaps (CDS), collateralized debt obligations (CDOs) that packaged dodgy mortgage- or asset-backed securities (MBS or ABS), the “originate to distribute” model of lending, offshore domiciles, borrowings of different priority arranged in tranches (remember tranches?), the global dollar glut and yes, whimsical names that should have warned investors to stay away.

I mean, who could forget the Whistlejacket SIV? When Whistlejacket failed, someone must have regretted not knowing, just what is a “whistlejacket,” anyway?

But why write about SIVs now, aren’t they soo 2007? I would give three reasons:

• First, banks are not done unwinding SIVs (not to mention CDOs and CDS) from their balance sheets. They may be out of sight but they are still out there creating mischief.
• Second, SIVs are still being litigated: as I wrote several weeks ago, a lawsuit over the now-bankrupt Cheyne SIV may help dethrone the bond rating agencies.
• Lastly, nothing epitomized the credit bubble like the SIV.

SIVs were to the credit bubble what Goldman Sachs Trading (GS) was to the Roaring Twenties, the Nifty Fifty to the ‘60s “go-go” markets, and pets.com to the internet bubble.

Ten or twenty years from now, when the consequences of all our actions have become clearer, someone will write the definitive history of the credit bubble. In such books, writers often organize their narratives around a particular item or incident. If any financial historians are reading this, I nominate the SIV; it wins hands down.

Why create a SIV? Commercial and investment banks (often the same company) enjoyed many benefits from SIVs, none of which passes the smell test now. Investment banks got to earn fees on the things, coming and going. Consider: they bought mortgage loans (or car loans, or loans against credit card receivables, among others) and got fees when these were packaged into ABS or MBS. They got fees again when they packaged the ABS or MBS into CDOs. They even got yet another level of fees when these were sometimes packed into, you guessed it, CDO-squareds or even CDO-cubeds. And at this point the investment banks were just getting started.

So the investment bank created the vehicle in which the SIV would typically invest, the CDO. The investment banks then sold notes to finance its CDO purchases. These notes usually came in several tranches such as short term senior notes, subordinated capital notes, and then at the bottom, some equity. The i-banks collected fees on each of these financings too. Not incidentally, the i-banks also had in the CDOs and SIVs, buyers, or more accurately, stuffees for all that dodgy loan product they had for sale. Oftentimes that loan product was originated for sale because the lender didn’t want to own it in portfolio.

Therefore in the SIV we had a special purpose investment company that was leveraged up, say, four to one (that is, they had four dollars of debt for each dollar of equity) to purchase CDOs that no one really understood (they were opaque). You couldn’t understand a CDO because each CDO typically owned pieces of dozens of MBS, which in turn were created from hundreds if not thousands of loans. So a CDO could comprise pieces of tens of thousands of loans, which no one had the time to evaluate; and that’s before we even get to an SIV that might own pieces of a number of CDOs. So if a CDO was impossible to analyze, an SIV, was, well, incomprehensible.

Finally, the amount of leverage SIVs had was not always apparent at first glance. Of course SIV note buyers knew that SIVs were leveraged; they were financing that leverage. But in addition, CDOs often incorporated leverage also. Therefore, a SIV often had multiple layers of leverage, because it owned leveraged vehicles like CDOs.

The SIV would sometimes hedge its credit risk with CDS that supposedly guaranteed the CDOs that it owned against default. That way, in theory, it was safe to borrow so much money and buy bonds with it.

Someone had to manage the investments of the SIV once it was launched, and commercial banks often seemed to benefit by doing that. Banks normally are limited by law, as to how many dollars’ worth of assets they can have per dollar of equity but by setting up SIVs banks could control additional assets beyond the legal maximum (here’s the regulatory arbitrage). Legally, the SIV owned the assets, the bank did not. The banks accounted for SIVs as “off balance sheet” items. The banks earned their money by charging the SIV a fee for managing the SIV’s assets. As an aside, banks often domiciled the SIVs offshore, typically in London.

On the other hand, SIVs posed a potential problem for the commercial banks that managed them. The bank was expected to step in if the SIV couldn’t repay its notes. When that happened the SIVs then “migrated onto the banks’ balance sheets.” While the banks were not always obligated legally to back the SIVs, they faced reputational risk if they failed to do so. Bank of America (BAC) and Citigroup (C) are among the banks that became reluctant owners of SIV assets.

Why buy notes issued by something like this? Three reasons come to mind:

• First of all, the i-banks would find some way to set up the SIVs (and the CDO components too) so that the senior tranches got AAA ratings from Moody’s (MCO) and S&P (MHP).
• Secondly, the SIVs often had the implied guarantees from commercial banks.
• There was also the “safeguard” provided by the CDS (another item in our abuses list) hedge in some cases.

Because the i-banks (and the rating agencies) sprinkled so much holy water on these things, that they could find buyers who didn’t bother analyzing the SIVs seriously. With all the supposed safeguards, the buyers were happy to get a yield that was, well, a bit higher than what you could get on Treasurys because, after all, the SIVs were triple-A. A classic example of reaching for yield.

Thirdly, some of the SIV buyers, particularly international buyers, had LOTS of money to invest, courtesy of the worldwide dollar glut. During the good times they didn’t think much about where they put that money. For example, one of the plaintiffs in the rating agency lawsuit is the Abu Dhabi Commercial Bank.

So there you have it: a product that embodied just about every sharp (or stupid) practice of the late stage credit mania. While we’d love to see financial markets heal even more, not even the wildest green shooter dreams that banks will bring new SIVs to market again. No one will miss them, either, except those of us who fancy the trivia of financial history.

Comments

[athena:]

Sounds like fraud to me.

Oct 04 09:44 AM

[griot:]

It's refreshing to hear someone articulately tell it like it is. Transparency is the key issue. Off balance sheet debt, dark pool ploys and the like have taken us to the abyss.

Oct 04 11:18 AM

[really:]

A little knowledge is a dangerous thing. Yes, SIVs were leveraged and if they bought certain instruments they could be more leveraged than they appeared. But, not all the SIVs did the same thing, though if you read the papers you thought so. This is not an area of finance that the average retail investors knows much about as these instruments were sold in the private 144a world to money market funds and short term debt funds. This writer doesn't seem to be familiar with the specifics of any particular SIV. Though Cheyne is mentioned, Cheyne was not the product of an i-bank. It was a newer independent SIV run by a hedge fund out of London (that should have been a warning right there). And, yes, Cheyne bought lots of CDOs and subprime mortgages. Also, he mentions Bank of America had to buy SIV assets. Bank of America didn't have any SIVs. It had money market funds that were threatening to break the buck because of the falling price of some of their SIV paper they held (some may not have paid later), but this wasn't an SIV asset, it was SIV debt. Also, to the best of my knowledge the Citi SIVs did not buy CDOs and stopped buying US MBS in 2005. About half the assets were in better quality financial institutions. Spreads and fear in the market are most of what ultimately did the Citi SIVs in. The assets are in run-off, but have not had the detrimental impact to the bank that was feared compared to the SIVs' size. There's been a lot written about the Citi SIVs, a lot of which isn't true. And, for a fact, the investment bank did not run that Citi business.

Oct 04 08:58 PM

[Jonathan Be...:]

Hi there Really, nice to have informed commenters who keep us writers on their toes. You are correct, Cheyne SIV was managed by hedge fund Cheyne Capital; it was marketed by Morgan Stanley (which is what landed MS in court). I don't disagree with you about assets in runoff mode; I think my usage, "being unwound," is pretty close in meaning to that. Nor do I disagree about different SIVs doing different things; I said (for example) that some employed multiple layers of leverage and some did not. As for Citi, I did not say or mean to imply that Citi's investment bank ran the SIV business, only that in some cases the bank and the manager were the same.

Oct 05 03:40 AM