More Questions, and My Answers, About Those “Leaky” SIVs

In response to a recent article (The Next Market Shock Meltdown on Wall Street: a Tale of M-LECs and SIVs), I received a number of reader responses. One email in particular covered a range of topics, and included some really good follow up questions for me. So I though that I would post it here, along with my responses, for the benefit of all readers. Enjoy…

Mike: Read your article from October 21, about SIVs. A couple of questions for you.

1)  I am assuming that money market funds and corporations that have excess cash to invest buy the commercial paper issued by SIV's.

Yes, some of this toxic commercial paper (CP) does in fact lurk in the portfolios of money market funds, in fact a few in the U.S. came under severe stress due to this issue in July, although no big funds had problems in terms of "breaking the buck" (when a money market fund falls below a dollar bid). Most of the SIV paper however resides with banks, brokers, hedge funds, and other institutional investors.

2)  Does the entity that sets up the SIV put up some cash to start the SIV?

Yes, in the case of Citigroup (the King of SIVs), they have started several with a total capital base of $300 billion . Some of this "seed capital" is put up by Citi itself, the rest is from outside investors.

3)  If you look at alot of these investment banks they have gone from 8 or 10% shareholder equity compared to total assets to 4% recently. So they have leveraged up. Looks like they are leveraging up even more using SIV's.

Exactly right! The spreads earned by the SIVs (the interest rate difference between their cost of borrowing, and the yield received on the debt they purchase) are pretty small to begin with, so it's a game of leverage, which is why the sub-prime credit crunch is far from over.

That's because there are several layers of leverage involved, making it more difficult for investors holding this paper to know just how big their ultimate exposure is. Whenever you add lots of leverage, even small changes in underlying asset value can result in huge losses (see Long Term Capital Management - or this year's example - Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund).

4)  You say that the "SIV's typically issue short term commercial paper to raise capital.  Then they turn around and leverage up the cash, typically 10-15 times." So who are the SIV's borrowing money from? If they default who is responsible for the losses on this borrowing.  Is the entity who loaned them the money stuck for the losses, or is the parent company/investment bank on the hook to pay in full the money borrowed by the SIV?

SIVs primarily raise money by issuing this asset-backed commercial paper, using their high credit rating (thanks to their cozy relationship with Citi, and other big banks) to borrow at relatively cheap rates, then invest this money in bundles of collateralized debt. In the event of default, technically the losses reside with the SIV, which means investors who bought CP from the SIV face substantial if not total losses, and the "seed capital" put up by banks and other investors would likely be a total loss.

This is essentially what did happen to those two Bear Stearns hedge funds back in June, which put the sub-prime credit crunch in the headlines.

Some SIVs are structured so a bank is explicitly on the hook in the event of default, and for other SIVs this backstop is implicit. However, the "speculation" is that a big bank with a reputation to protect (like Citi) would never allow one of its SIVs to fail outright.

If that were to happen, then Citi would have a hard time selling another similar structured product to investors down the road. So the more likely scenario is for the bank to "wind down" the SIV by taking the assets back onto its own balance sheet; and sell them in a more orderly fashion, rather than at fire-sale prices in a panic liquidation.

That's why a group of Wall Street firms, led (not coincidentally) by Citigroup, is in such hurry to set up this M-LEC with the Treasury Department's blessing. Such a vehicle would serve as a sort of "weigh-station" for moving assets out of troubled SIVs, but without bringing them onto the banks' own balance sheets. It's essentially replacing one shell-company, with another shell-company, but the shell game is allowed to continue.

5)  It would seem that if the SIV market implodes, there will be a rush to buy short term treasuries (short rates will go down) and a forced sale of long term debt causing long rates to go up.

Two year Treasuries have in fact been soaring in price (sending short-rates lower) since August when CP markets began to seize up. There may or may not be a “forced sale” of long-term bonds, it depends on the type of debt. Treasury bonds for instant may actually attract buying as a “flight to quality trade”. But I would be leery of “risky” debt securities, such as high-yield corporate bonds, which suffered some distress during July and August.

If the SIV market does "implode" in a big way, with several forced liquidations then, to paraphrase the great Warren Buffett: we would have an extreme-low tide of liquidity and we'd find out exactly how many Wall Street firms were swimming naked... which would be a very ugly sight to see!