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Wednesday, December, 5, 2007

Structured Investment Vehicle (SIV): Bankruptcy remote entities set up by financial institutions that sell short-term commercial paper and invest the proceeds in high yield, long-term debt.

SIV IN THE REAL WORLD: Picking up where Pocket MBA left off last week....When this column started five years ago, PMBA, the individual, was a finance neophyte. Now, with a couple hundred of these issues in tow, especially the one on CDOs, too many hours logged watching business television (and when you're watching Bloomberg and CNBC World at 3:00 a.m. to follow the Alibaba IPO, you're way too involved..."Booyah Cramer, this is PMBA in New York, is my existence a buy or a sell?"), PMBA knows the true meaning of "plus ça change, plus c'est la même chose." When this newsletter began, Enron had recently imploded, the victim of its own nefarious, off-the-books financial arrangements known as Special Purpose Vehicles that, along with some sleight-of-hand balance sheet shenanigans, hid the dire financial condition the company was in. Heads rolled, people went to jail, FASB made some new accounting rules and Congress passed a law, not necessarily in that order, that everyone thought put an end to such arrangements.

Fast forward, or as some would say, go back to the future, and you have many of the world's leading financial institutions trying to dig their way to the valuation bottom of a different kind of off-the-books investment vehicle. Only this time around, the government—via the Fed's monetary policies and in the person of Treasury Secretary Henry Paulson, who is trying desperately to corral the banks into financing a multi-billion dollar superfund to buy troubled debt from the investment vehicles most affected—isn't in a prosecutorial mood, if even there were anything to prosecute, though the SEC has announced that it will be looking into some banking balance sheets. So even while heads have rolled (Merril Lynch, Citigroup), no one appears to be headed for jail, and the nation doesn't seem to have the appetite for a Sarbanes-Oxley 2. But who knows what we might end up with if things don't wind up in the next six months to a year.

Anyway, PMBA is not offering political commentary here, merely noting irony that others far more qualified (economists mostly) have noted elsewhere. PMBA recognizes the distinctions between then and now: by 1999-2000, Enron was an illusion, a house of cards waiting to come down, whereas the players involved now earn billions and billions a year independent of any write-downs they make on CDOs or any bailouts of SIVs they will attempt. Also, the current economy is better than not—despite the sub-prime "crisis," most (almost all) mortgages are not in default, and the most recent GDP report showed strong economic growth, strong productivity growth and a decent labor market, not to mention a rip-roaring export market, courtesy of a weak dollar and global hyper-growth. There seems to be no economy-wide bubble à la the tech wreck of 2000-01 waiting in the wings. And therein lays the difference between then and now, at least for now. That may change. Still, our prime concern today is simply to determine what an SIV is, and for many readers who have exposure to structured finance, this will be entirely too simple.

SIVs have been around only since 1988, and the first two were set up by Citigroup. There aren't even that many SIVs now, with one count finding 29 in total, but they represent hundreds of billions of dollars. They are bankruptcy-remote (that basically means if they go belly up, their corporate sponsors are not on the hook for their debts), limited purpose entities, generally set up offshore, away from the watchful eye of regulators. They make money by a simple arbitrage-like strategy: they raise money by selling short-term, low-yield, asset-backed commercial paper and then invest the proceeds in longer term, higher yielding debt, such as bonds and mortgage-backed securities. They use the cash flow from the higher yielding investments to roll over (pay off) the commercial paper, and whatever is left is profit.

If you want to remember the SIV investment strategy in an acronym, just remember B-STiLL (which these days might well mean "be still while the value of your portfolio plummets," but Pocket MBA digresses). B-STiLL = Borrow ShorT, Lend Long. It's a great strategy unless investors refuse to buy the commercial paper that finances the long-term debt, which is precisely what happened this past summer. There are a number of reasons, investors can bag out. An inverted yield curve is poison to this type of investment strategy—low long-term yields undermine an entity's ability to pay the suddenly higher short-term yields. So is a situation in which investors don't trust the valuation or credit soundness of the holdings in the long-term debt.

For a more legalistic explanation of a SIV, PMBA recommends you to Gary Barnett (Linklaters), who penned the outline Structured Investment Vehiclesfor the PLI course handbook New Developments in Securitization 2007:

Structured investment vehicles (SIVs) fund a diversified portfolio of highly rated assets by issuing US and Euro Commercial Paper (USCP and ECP), US and Euro Medium Term Notes (USMTNs and EMTNs) and Capital Notes. SIVs earn a spread between the yield on the assets and funding costs to pay a return to Capital Note holders and generate fee income for the Investment Manager by managing credit, interest rate, currency and liquidity risks and maintaining minimum levels of overcollateralization while marking assets to market each day. SIVs are organized as bankruptcy-remote special purpose vehicles in beneficial tax jurisdictions such as the
Cayman Islands
. The SIV issues ECP and EMTNs and, through a
Delaware
entity, co-issues (or guarantees) USCP and USMTNs which are respectively rated A-1+/P-1 and AAA/Aaa. The proceeds are used to purchase debt securities, which typically have a weighted average rating of AA. The SIV enters into Hedge Agreements to manage interest rate, foreign exchange and credit exposure and Liquidity Agreements to provide liquidity for the short-term liabilities in the event of market disruptions and for the benefit of Senior Creditors during Enforcement Operations. The interest and principal received from assets are used to pay interest and principal on liabilities and to redeem liabilities.

Remember...B-STiLL.

Because the SIVs currently of concern were invested in mortgage-backed securities, the soundness of the yields on their paper was backed by these mortgages, which all of a sudden, didn't look so sound. As the subprime mess unfolded, nobody wanted the financing bread and butter of the SIVs, which is the cheap, short-term paper, precisely because it didn't seem safe anymore, at least not as safe as parking money in treasuries that also carried higher yields due to the inverted yield curve. But the SIVs still had to pay off the maturing commercial paper they had already issued. What to do? Put yourself in their shoes. If you lose your job and you have bills to pay, you can either borrow money (difficult), or you can sell your better assets, even at a discounted price, to pay the bills. Of course, that process cuts into your profit and can even send you into bankruptcy.

If this process had been confined to one, isolated entity, nobody would care all that much, save the investors in the particular SIV. The problem is that it is affecting all the SIVs, which could lead to a mass liquidation of their long term debt. And if you end up with a mass liquidation of SIV assets, that means even lower prices. The market would be flooded, which would impact lending markets far and wide. That's where the banks are stepping in, at the behest of the Secretary of the Treasury, with their so-called superfund to buy this paper in a controlled manner to avoid the stampede and concomitant depression of prices. And some are concerned that the superfund has a prime impact of bailing out Citigroup, one of the fund's investors, which operates seven SIVs off its balance sheets. Very confusing.

Beyond that, there is a nagging, potential legal issue. As noted, the SIVs have generally been set up with off-balance sheet arrangements. That is, they are legally distinct from their sponsors—the banks didn't issue the equity in the SIVs; the SIVs raised money independently and have their own investors (called "capital-notes holders"). So the banks are not responsible for SIV losses—that is, as noted, the SIVs are bankruptcy remote. But the banks are the sponsors and managers of the SIVs, and some wonder if, therefore, they may be on the technical hook in the event the SIVs starts to swirl the drain. And if they are on the technical hook, are they actually on the legal hook, under FASB rules, to show the SIVs on their balance sheets? That is a question that some are beginning to ask. See, e.g., this recent Bloomberg article. And if the banks are required to carry the SIVs on their balance sheets, what will be the impact of those restatements? The latest intrigue in all this is General Electric Asset Management's announcement that a bond fund it runs (one requiring a share price of $1.00) that had been invested in these types of arrangements would have to sell its assets, and investors could only expect $.96 on the dollar if they redeemed their shares as the fund unwound. If there's a lot more than one of those around, watch out below. And so you see, that's where Pocket MBA Volume 5, No. 44 begins to seem so much like Volume 1, No. 1. It's very much back to the future.

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