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.
SIVs differ from asset-backed securities and collateralized debt obligations in that they are permanently capitalized and have an active management team.
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.
In 1993, Sossidis and Partridge-Hicks left Citigroup to form their own management firm, Gordian Knot, located in London's Mayfair.
"[6] 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.
[7] 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.
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.
If it could, market participants with low funding rates would simply purchase the financial assets directly, and capture the spread for themselves.
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.
The gathered funds are then used to purchase long term (longer than a year) bonds with credit ratings of between AAA and BBB.
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.
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 junior debt traditionally comprises puttable, rolling 10-year bonds, but shorter maturities and bullet notes became more common.
This explains why the borrowing side of SIV consists of fixed term (30 to 270 days) rather than on-demand (1 day) deposits; however, in extreme circumstances like the 2007-8 credit crunch, the worried usual buyers of CP, facing liquidity worries, might buy more secure bonds such as government bonds or simply put money in bank deposits instead and decline 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.
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.
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.
The most significant among these assumptions were the trends in U.S. housing prices which declined far faster, deeper and broader 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.
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.
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.
Unlike standard asset backed commercial paper conduits, SIVs do not have liquidity facilities that cover 100% of their outstanding CP.
Instead, a SIV's safeguard against being unable to issue new CP to repay maturing paper is being able to sell their assets, which were until then both highly rated and liquid.
In August 2007, 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.
[13] Northern Rock, which in August 2007 became the first UK bank to have substantial problems from being unable to issue mortgage securitisations to fund itself, was nationalized by the British government in February 2008.
[15] Central banks failed to heed Bagehot's dictum "to lend to all, against good collateral but at a penal rate" and to provide funding to the SIV during the liquidity crisis.
On 2 October 2008 the Financial Times reported that Sigma Finance, the last surviving and oldest of the SIVs has collapsed and entered liquidation.
The US Government's Commercial Paper Funding Facility (CPFF), created under the TARP legislation became available to CP borrowers on 27 October 2008.