Structured Investment Vehicle (SIV)
Complex financial entity that pools and invests in a portfolio of securities, often backed by mortgages and other debt instruments, aiming to generate returns through the issuance of short-term commercial paper
What Is a Structured Investment Vehicle (SIV)?
Structured investment vehicles are a way of investing in long-term assets (with a credit rating of AAA or BBB) by issuing commercial paper. Then, they borrow the money from commercial paper and buy high-credit rating assets such as mortgage-backed securities.
Financial firms use structured investment vehicles. For example, financial firms will use the credit spread to profit between short-term debt and long-term investments. It allows them to leverage themselves in a way that the parent company would not be able to due to regulations.
The capital for SIVs comes from a commercial paper continuously rolling over. It allows financial firms to keep pushing more and more money into investment vehicles.
Some assets inside the investment vehicles can be:
- Mortgage-backed securities (MBS)
- Asset-backed securities
- Collateralized debt obligations (CDOs).
Companies can make money because the return on investments is higher than the cost of short-term debt.
SIVs were created in the late 1980s and could leverage five times the original capital. They were able to leverage ten times the initial capital. SIVs are less regulated and usually kept off the balance sheets of financial institutions.
Key Takeaways
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Structured Investment Vehicles (SIVs) enable financial firms to invest in high-credit rating assets, leveraging short-term debt for long-term gains through instruments like mortgage-backed securities.
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SIVs, created in the late 1980s, leverage commercial paper to achieve returns, often exceeding initial capital, with less regulatory scrutiny compared to parent companies, offering financial institutions a means to navigate regulatory constraints.
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SIVs source capital through continuously rolling over commercial paper, facilitating increased investment in assets like mortgage-backed securities, asset-backed securities, and collateralized debt obligations.
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The profitability of SIVs relies on the spread between the yields of long-term assets and the cost of short-term debt, allowing financial institutions to profit when returns on investments surpass the expenses of short-term borrowing.
What are SIVs used for?
Large financial institutions use structured investment vehicles to leverage debt into making a profit on long-term quality assets that will provide a return more prominent than the short-term debt incurred. They can do this through the operation of a credit spread.
Financial institutions will issue commercial papers, which are short-term unsecured promissory notes issued by companies. The institution will use the capital gained from this and buy long-term assets.
Assets that the institutions may buy are asset-back securities, mortgage-backed securities, and collateralized debt obligations or CDOs. These investments are less risky and are likely to give more significant returns than capital borrowed from commercial paper.
Assets institutions invest in have longer maturity dates than the money borrowed, but the investments have higher yields. Such as, if one borrows from the money market at 1.5% and then invests that money in a long-term asset that pays gains of 2.7%, they will earn 1.2%.
The difference between the interest payments is what allows the institutions to make a profit. Once the commercial paper has matured (generally up to 270 days, with an average of thirty days), it will issue more debt to acquire more assets.
The renewal and re-issuance of the commercial paper allow the institutions to gain a significant amount of leverage to profit from the assets they invest.
What is the history of structured investment vehicles?
The first structured investment vehicle was Alpha Finance Corporation, created in the late 1980s by Nicholas Sossidis and Stephen Partridge of Citibank. They could leverage the bank's initial capital by five and later ten times larger than the initial amount.
The SIVs were one of the biggest threats in the financial crisis of 2007-2008. Many people did not know what the SIVs were, and they rushed to find out what they were and the impact they would have on the financial markets.
The SIVs controlled hundreds of billions of dollars in assets, and although SIVs were meant to be invested in high-credit rating assets, some were not. Instead, depending on the credit rating of the support, the investment vehicles could have been considered SIVs or conduits.
During the Great Recession of 2008, SIVs either failed or were restructured. This was because many of the investment vehicles were invested in mortgage-backed securities. It started after the government lowered interest rates to stimulate the economy after the dot-com crash.
When predatory lending started to rise, everyone could reach the dream of buying a house (even people who should not have been capable of doing so) because interest rates were so low. Then, years later, people couldn't afford their house payments after rates started to rise.
When people could not afford to pay the price of their homes and couldn't sell their houses and spend the lenders the rest of what they owed, consumers started to file bankruptcy. Suddenly, families could not pay the mortgages placed in the SIVs.
Example of an SIV
Here is an example of how a structured investment vehicle works:
Suppose a bank wants to diversify its holdings and earn income on other assets. So the bank creates a new bank division and starts buying bonds from money markets. The division issued commercial paper to finance the buying of the bonds.
Let's assume that the bonds are mainly mortgage-back bonds with a complex organizational structure that includes other entities. Other entities, such as state districts and financial institutions, bought these bonds and rolled them over for the investors.
If mortgages are being paid, then those mortgage-backed securities are outstanding. It is because the entities and people who bought the commercial paper are receiving their yield from the institution receiving the product from the mortgage-backed securities.
Although once a large number of people could not afford their homes, the mortgage-backed securities became worthless, and the financial institutions were not receiving any yield from them. Therefore the institutions either went bankrupt or were saved by another bank.
SIV vs. SPV
The main difference between a Structured Investment Vehicle and a Special Purpose Vehicle is how they get funding for the investments they pursue.
Some of the differences are:
- SIVs are specific types of SPVs, and SIV is a branch of the broad term SPV.
- SPVs are created for a specific purpose. First, companies create them to make profits from an offshore orphan company. They do this to avoid paying higher taxes in the parent country.
- SIVs are also registered as offshore companies. They usually are controlled by a professional administrator who will manage the accounts to ensure no connection between the finances of the orphan and the parent company.
- The only significant difference between SIVs and SPVs is how offshore companies are funded. For SIVs, these companies are financed by issuing commercial bonds to others. On the other hand, SPVs can be funded in various ways, such as by giving equities, securities, and adhesives.
- Another example of an SPV is a traditional conduit. Conduits are less risky than SIVs because SIVs do not have support pipes. Tubes have liquidity agreements and lines of credit that help support them.
SIV vs. Conduits
Conduits are companies set up by banks to issue financing to other companies and investments. Conduits can be used for large projects or investment-related activities. For example, they can raise money for hospitals, schools, or industrial centers.
Conduits finance their projects or investments through conduit bonds. The issuers of the bonds are responsible for paying the interest. Most of the time, the bonds are paid through the revenue gained from the projects or investments.
The difference between SIVs and conduit financing is that the investors buying commercial paper inherently have less risk in their investment because the securities the financial institution invests in generate yields from the start. It is sometimes different with conduits.
Investors in conduits invest in the projects that the conduit bond issuers are starting. It means they are inheriting more risk because the project may not finish, or it could potentially fail after completion.
Although, the benefit to conduits is they pay higher yields compared to the investors because they issue more risk. Commercial paper investors have less chance because the company they are investing in is not at such risk of losing investments.
Conclusion
SIVs were created in the late 1980s by Nicholas Sossidis and Stephen Partridge of Citibank. These were designed to diversify and make other streams of income. Financial institutions would do this by issuing short-term debt through commercial bonds and buying long-term assets.
SIVs make money through the difference in the yields of long-term assets and short-term debt from commercial paper. For example, if you issue a retail report at 1.5% interest and buy long-term investments yielding 3%, your profit is 1.5% interest.
Commercial paper will expire within thirty to 270 days. The financial institution will keep issuing debt to buy more long-term assets throughout this process. It is an excellent investing system if the assets you buy hold up and can still produce a high yield.
Institutions would roll over the commercial paper to keep buying these assets, including mortgage-back securities, asset-backed securities, and collateralized debt obligations (CDOs). Unfortunately, this investment strategy was hit very hard during the recession of 2008.
The most significant differences between conduits and SIVs are the number of risk levels. When an investor buys commercial paper, they are investing in a company investing in longer-term assets that produce higher yields. Conduit bond investors are investing in company projects.
During the recession, people could not pay the mortgages on the homes they paid for; these were all the same mortgages in the mortgage-backed securities. So when people started defaulting on their loans, the guards became worthless.
Once the securities were worthless and the institutions were not receiving any money, they could pay back the money they borrowed through the issuance of commercial paper. As a result, the financial institutions went bankrupt or were bailed out by other banks.
FAQs
Structured investments profit off a credit spread through borrowing money through commercial paper and buying long-term assets.
SIVs are an investment by borrowing money through commercial paper, SPVs gain capital for investment in other ways, such as issuing equities or long-term bonds.
Investment vehicles can include open-end mutual funds, closed-end mutual funds, and exchange-traded funds (ETFs).
Commercial paper is not like equities; they are money market securities issued by large companies.
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