Structured Investment Vehicle (SIV)

What is a Structured Investment Vehicle (SIV)?

A special investment vehicle (SIV), also known as a special purpose vehicle (SPV) or a structured investment vehicle (SIV), is a non-bank financial entity designed to raise funds from the markets through securitization. The SIV profits from the difference in market spread between short-term debt and long-term structured finance products. 

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Nicholas Sossidis and Stephen Partridge-Hicks, London bankers, created the first two SIVs back in 1988/89 for Citigroup. The special investment vehicles were called Alpha Finance Corp. and Beta Finance Corp. They used increased leverage - 5 and 10 times respectively - to maximize returns. 

The sector peaked in the run-up to the Great Financial Crisis (GFC) with almost $400 billion of assets under management (AUM) in July 2007. It dropped by a staggering 50%, to $200 billion, by mid-December of the same year, according to Moody's, the rating agency.

In order to help understand the nature of the SIV, we need to break down its key elements.

Securitization

Securitization is the process of transformation of non-tradable assets into tradable securities. In the case of the SIV, this method means creating a pool of debt instruments, such as loans or mortgages. New securities, backed by the pool of debt instruments, are issued and sold to investors in order to raise capital. 

A very prominent example of securitization and the subsequent creation of a structured finance product is the mortgage-backed securities (MBS), which became a hot topic during the 2008/09 GFC. As part of this, a collection of subprime risky mortgages were pooled together. The issuance of new securities, backed by those aggregated mortgages, was then sold to investors. 

These investors didn't buy the actual mortgages and weren't necessarily aware of the underlying risks, notably credit risks. However, through the issuance of the new securities the investors had a claim on repayment in the event of a default. The default is the inability to keep up with the mortgage repayments. When defaults started to occur, this triggered a contagion, a domino effect in a certain way, that spilled over and across the economy. The MBS is a typical illustration of a structured, or synthetic, finance product.

Types of Debt

In finance, debt simply relates to the lending of money at a specific interest rate over a certain period of time - eg. a bank lending money to a business to purchase equipment or to an individual to purchase a car, for instance. The party receiving the money is called a debtor and the party lending the money is called a creditor. 

There is a contractual relationship between the two parties: the debtor has to repay the borrowed money along with the interest to the creditor; failure to do so can result in seizing of assets, the company's equipment, and the individual's car in the example above, by the creditor to recover the cash that was lent. Debt securities are typically known as fixed-income securities. Bond prices and their coupon rates, the interest rate they pay, move in opposite directions - higher yield brings the price of the bond down and vice versa. 

Based on its term, also called its maturity, debt falls into three categories.

Short-Term Debt

This type of debt has a term of less than a year. Short-term debt securities are temporary investments that can be easily converted into cash. Companies and governments can issue these marketable securities. These temporary investments facilitate and provide liquidity. Short-term debt offers a range of instruments, which expire within 12 months, such as U.S. Treasury bills, certificates of deposit, commercial paper, or eurodollar.

  • U.S. Treasury bills - They are issued by the government. Equally known as T-bills, the Treasury bills are issued in denominations of $1,000 and sold at an auction at competitive and non-competitive bids. Non-competitive bidding represents the average of all competitive bids. Competitive bids are offered by individual investors and these bids represent the desired price an investor is willing to pay. T-bills are issued to fund infrastructure projects. They don't pay regular coupon payments, however, they still pay interest. The interest is reflected in the difference in the price of the instrument at issuance and maturity.
  • Certificates of deposit (CDs) - Commercial banks or brokerages can issue certificates of deposit of up to $100,000 value. The CDs are not publicly traded, that is they're not available on stock exchanges. These instruments can be traded in the money markets and are protected by the Federal Deposit Insurance Corporation (FDIC). Certificates of deposit are low-risk investments with a low yield. CDs in foreign currency can be bought through overseas or U.S-based banks and represent a good currency risk hedge.
  • Commercial paper - This is a written document or instrument that one entity will pay money to another. Commercial papers are unsecured, short-term loans issued by a company with high credit ratings, typically above A, for financing inventories and accounts receivable. Unsecured debt means that the creditor may not be able to recover losses due to the debtor's default as the debtor hasn't pledged an asset. Unsecured debt is also an uncollateralized debt.

Commercial papers are available in different denominations and their maturity ranges from 2 to 270 days.

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Mid-Term Debt

Mid-term debt is a type of debt that has a maturity between 2 and 10 years. Also labeled intermediate, the mid-term debt comprises mid-term notes, including Treasury notes, some bonds, growth, and income funds. The yield of the mid-term securities, or the interest rate, is higher than that of the short-term investments, but lower than the interest rate of long-term securities. 

The yield on mid-term debt is higher because it takes into account the interest rate risk as well as the fact that longer investments are subject to more risks for which investors need to be appropriately compensated. Investors also require a higher rate of return for debt instruments with longer maturity - the interest rate and the length of the term are positively correlated.  

Mid-term notes (MTN) - Unlike a traditional bond that can be issued only once, mid-term notes can be issued many times by a company looking to finance its mid-term operations. Mid-term notes don't require extensive legal documentation every time an issuance takes place. Instead, the initial legal requirements can be updated to accommodate the new issuance. 

Usually, MTNs are required to be registered with the SEC. On some occasions, they're exempt from registration - this requires the MTNs to be under a banknote program purchased by qualified institutional investors only. Companies with investment-grade credit ratings can issue mid-term notes, which are often used as a senior, uncallable, uncollateralized debt. 

Treasury notes - Also called T-notes for short, the Treasury notes are U.S. government-issued debt instruments that pay interest every six months for the entire note term. They have a maturity range from 2 to 10 years. T-notes can be bought from Treasury Direct, a bank, or a brokerage firm. 

MTNs and T-notes can be used to diversify a portfolio and help mitigate the total portfolio risk. These fixed-income instruments are subject to the relevant tax codes and regulations. 

Long-Term Debt

As the name suggests, long-term debt is issued for periods longer than 10 years. An interesting example of long-term debt is Austria's 100-year government bond which yielded less than 1% in 2020, the rate influenced by the very low rates at the time. 

The U.S. government issued the first 20-year bond in 2020, in addition to its already existing 10 and 30-year bonds. 

Government bonds are considered to be less risky than corporate bonds since the default risk is minimized. Conversely, companies that issue fixed-income securities command an interest rate that is higher than those of Treasuries as the risk of default and not being able to honor the debt repayments is also higher.

Government bonds are known as sovereign bonds in Europe, gilts in the UK, OATs in France, bunds in Germany, and BTPs in Italy.  

Long-term fixed-income securities are categorized from low to high risk as follows:

  • Treasuries
  • Municipals 
  • Investment-grade bonds
  • Intermediate-grade bonds
  • High-yield junk bonds 

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What Are Structured Finance Products?

Structured finance products have been in existence since the 1980s but have come into the spotlight due to their role in the 2008/09 Great Financial Crisis. They are also known as market-linked investments. These complex instruments were created to meet the financing requirements of companies and institutions whose investment needs couldn't be satisfied by traditional financial products, such as conventional loans.

Structured products were mainly created for borrowers - large corporations - who could commit a large amount of capital.

A structured product can be based on a single security, a basket of securities, indices, commodities, currencies, etc. The cash flows of the structured product depend on the underlying asset and its fluctuations. It is not uncommon for a structured product to contain embedded options or forwards, types of derivatives.

How Are SIVs Organized?

Synthetic finance products are organized in tranches. A tranche (meaning slice in French), especially in debt securities, represents a part of the pooled investment that is characterized by its time to maturity, rating, and risk, among other factors. Each tranche has its own return and risks characteristics and, as a result, will be suitable for a particular type of investor. This makes structured products appealing to a large number of investors. They are, therefore, able to accommodate different investment needs and respond well to the different risk and reward appetites.  

The larger number of investors will bring more revenue to the investment bank, which creates those advanced finance products, through various charges, such as processing fees.

Each tranche is ranked from senior to junior-senior tranches have high credit ratings, as established by rating agencies, minimized default risk, and lower yield. Conversely, junior tranches present an increased default risk, which is compensated by a higher rate of return. 

In the event of a default, investors who bought senior tranches of the instrument are the first to have claims on repayments through collateral. Collateral refers to the pledged asset that the creditor can use to recoup payments if the borrower is no longer able or willing to make payments.

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Types of Structured Products

Among the most common and widely used types of structured finance products are: 

Hybrid Securities

As the name suggests, hybrid securities are securities that have portions of both debt and equity. A typical and well-known hybrid security is the convertible bond - a debt instrument that can be converted into equity when particular conditions are met. The convertible bond is affected by the price fluctuations of the stock into which it is converted.

A convertible bond can be an attractive investment and yield more than a traditional bond if the company's stock performs well. As with all investments, the convertible bond is subject to various risks, for instance, early repayment risk, default risk, interest rate risk, price volatility, and lack of liquidity. 

Convertible preference shares and convertible notes are two other types of hybrid securities. Convertible preference shares pay dividends at a fixed or floating rate and can be converted into the company's stock. A convertible note is an unsecured, subordinated instrument, which has a riskier profile as it ranks lower in seniority compared to other debt instruments.

Syndicated Loans

This is a type of loan that is provided by a group of banks and non-bank institutions to a single borrower. A syndicated loan is generally a source of financing used by large corporations across Europe and the US. It is arranged and administered by one or many commercial or investment banks, called lead arrangers.

The syndicated loan allows individual lenders to spread the risk and enables them to take part in ventures, which may exceed their capital base. The loan has a term, an interest rate, and a repayment schedule.  

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Collateralized Debt Obligations (CDOs)

A synthetic finance product, the CDO is an asset-backed security (ABS) and represents a collection of securitized debt investments sold to investors and backed by collateral. The issuance of CDOs is funded by the purchase of other portfolios of assets, such as commercial loans, corporate bonds, and also ABSs and mortgage-backed securities (MBS) issued by other special investment vehicles. 

These debt investments can include credit card loans, car loans, student loans, and bonds among others. At the end of the term, the holders of CDOs can retrieve the borrowed capital from the initial borrower. CDOs were initially developed for the corporate bond market. However, over time they were actively used for the issuance of MBS.

Collateralized Bond Obligations (CBOs)

Another structured finance product, CBOs are complex debt instruments. The securitization of a pool of investment-grade bonds is backed by high-yield low-grade junk bonds that serve as collateral. The issuer of CBO is known as a protection buyer. Because junk bonds have a higher interest rate than investment-grade corporate bonds, they are used in various proportions in the different tranches of the CBO. Senior debt, mezzanine debt, and subordinated debt and stocks are part of the tranches. The different tranches organize the priority of payments for the different debtholders. 

Collateralized Mortgage Obligations (CMOs)

CMOs are a type of mortgage-backed securities, mainly but not solely issued by U.S. state agencies or government-back enterprises. CMOs are issued by third parties who through the issuance of these new securities obtain funds for creating new loans. Based on extensive and complex data, the issuer of the CMO will decide what portion of the principal and the interest of the underlying mortgage loan will go into each tranche. Usually, the cash flow from the mortgage loans is used to pay the interest in all tranches. 

The principal, which is both scheduled payments and loan prepayments, is established through a complex schedule. The loan prepayment, or the settlement of debt before its due date, is a major risk for CMOs as it can affect cash flows. The prepayment is influenced by interest rates - decreasing interest rates can shorten the life of the CMO as the mortgage is paid more quickly or being refinanced while increasing interest rates can prolong the life of the CMO.

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Collateralized Loan Obligations (CLOs)

A CLO is a type of a CDO, which is based on a loan that is a form of debt. A number of corporate loans are pooled together, including high-risk loans and loans made to private equity (PE) firms for leveraged buyouts (LBOs), and sold to investors through securitization. Each CLO is made of tranches with different maturities, credit risks, and payments. The tranches of a CLO are organized on the principle of priority - debt tranches have priority of payments over the equity tranches. 

Equity tranches don't receive payments whether in the form of principal or interest, however, they offer ownership in the CLO in the event of a sale. A CLO is an actively managed instrument. The collateral that backs the pool of loans comprises first-lien senior secured bank loans made to a range of borrowers, typically 150-250 companies. 

Credit Default Swaps (CDSs)

A credit default swap is a contract, which references single or multiple credits between two parties for the transfer of credit risk. The credit risk can come from emerging market bonds, MBSs, municipal bonds, and corporate debt. The buyer of the CDS transfers the credit risk onto the seller in exchange for regular fees, acting as an insurance premium. The seller of the CDS benefits from the regular payments as long as a negative credit event does not occur. 

In the event of a default, the seller must compensate the buyer by delivering the principal and the interest on the bond involved in the transaction. The CDS only references the bond which is called reference obligation. The CDS has two main functions - to hedge against default and for speculation. The CDS market is an over-the-counter (OTC) market that is unregulated and hard to value.

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Purposes and Benefits of SIVs

Structured finance products and their complex nature have a number of benefits, which, if used correctly, can enhance market liquidity, provide a hedge against unfavorable events, and facilitate access to emerging markets among others.

As a risk management tool, structured products can mitigate credit risk through the use of credit derivatives - CDOs, MBSs. Interest rate risk can be effectively minimized by using CDSs. 

Structured products through the process of securitization provide more investment options to satisfy specific investment objectives that can't be otherwise met through traditional finance products (bonds, loans, equity). Asset-backed securities, which include CDOs and MBSs, can enhance investment returns, especially when the market doesn't.

In addition, these advanced products are tailored financial products that provide more personalized solutions for niche business needs. They also allow access to capital for companies with various investment grades and give investors a greater choice for risk and reward. 

Credit derivatives enable commercial and investment banks to shift the credit risk away from their balance sheets and onto investors such as pension funds, trusts, insurance companies, etc. This way, the financial institutions, the sponsors of an SIV using these structured finance products, can undertake riskier ventures without breaking any regulatory requirements for capital reserves, debt-to-equity ratios, and so on. 

The SIV is an off-balance sheet item because it's not recorded on the parent company's balance sheet and doesn't appear as an asset or liability. An off-balance sheet item is not owned by the company and the company doesn't have any associated obligations.  

Another benefit of SIV is the ability to facilitate the transfer of assets to investors. Non-transferable assets, such as property investments, and the process of securitization of non-tradable investments, such as mortgages, are typical examples of asset transfers. 

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Disadvantages of SIVs

The risk associated with the issued debt obligations - In the event of default of the mortgage owner, the SIV may not be able to ensure payments to investors, based on the tranches of the financial product. The prioritization of principal and interest payment ensures that each tranche is paid first before payments are made towards subsequent tranches that sit lower in the prioritization. The higher the risk of default the lower the prioritization ranking for a tranche. Investors who seek above-average returns also bear the increased risk, for which they are compensated through the higher interest rate.

In addition to the default risk, SIVs also present a risk regarding the debt rating of the different tranches. Given the complex structure of the collateralized obligations, it can be challenging for rating agencies, for example, Moody's and S&P, to accurately estimate the riskiness and creditworthiness. The unraveling and the contagion of defaulting mortgage payments shed light on the fact that some debt instruments had a worse credit rating than initially estimated. 

The insolvency risk is another risk that has to be taken into account. If the value of long-term investments falls there is an increased risk of insolvency, since SIVs make profits from the difference between selling short-term debt, usually asset-backed commercial paper (ABCP), and buying long-term assets. Prior to 2007, ABCPs were considered liquid, long-term assets that had high credit ratings, and the maturity mismatch between them didn't give reasons for concern. 

A maturity mismatch means that short-term liabilities exceed short-term assets, that is - a company, for example, may not be able to meet its debt obligations as its assets, for instance, cash inflows, are insufficient to cover them. The issuance of short-term debt can create liquidity challenges. Further, the issuance of short-term debt can become problematic if it's used for the funding of long-term assets. A maturity mismatch is also referred to as a liability-asset mismatch.

A number of metrics exist to help gauge an insight into a company's liquidity position and flag any potential concerns. Among those metrics are:

  • Liquidity ratio - Also called the quick ratio, it measures the function between current assets and current liabilities where:

Quick ratio = (Current assets - inventories) / Current liabilities  

  • Solvency ratios - These ratios provide information about the long-term financial health of a firm. The debt-to-equity and debt-to-assets are two useful metrics where:

Debt-to-Equity = Total debt / Total equity 

Debt-to-Assets = Total debt / Total assets 

The solvency ratios are expressed in percentages. The higher the percentage the higher the risk of financial distress for the company. The higher percentage also indicates that it is going to cost more for the company to raise funds through debt instruments. 

Reputational risk - The reputational risk affects the parent company, or the sponsor, of the SIV. If the special investment vehicle underperforms or, worse, defaults, this can have a negative impact on the sponsor. The credit rating of the parent company could be affected. However, if the parent company experiences negative financial events, the SIV is not affected as it is an independent entity. An SIV is also known as a bankruptcy-remote entity.

This creates an asymmetric relation between the sponsor and the SIV as far as unfavorable events are concerned.

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SPAC

A SPAC, a special purpose acquisition company, is a type of SIV in the form of a corporation. Partnerships, trusts, LLCs can also be examples of special purpose investment vehicles. These legal and independent entities are created to fulfill a specific business purpose. 

The main goal of a SPAC is to raise funds from both retail and institutional investors through an initial public offering (IPO) to acquire or merge with another company. The SPAC is an entity that has no revenue or business operations and its sole purpose is the acquisition or the merger with the target company. It is colloquially known as a blank-check company. 

The founders or sponsors of the SPAC create this entity in order to pursue business opportunities in an area or industry in which they have expertise and competence. The target company is not initially identified as it would require additional scrutiny and disclosures during the IPO stages. The disclosure can result in complementary regulatory requirements that could prolong the process.

The IPO is handled and organized by an investment bank that charges on average 10% of the proceeds. 

The capital raised from investors is placed in a trust and invested in U.S Treasuries. It is not until after the IPO that investors know the target company. 

If the IPO is not completed within a specified timeframe, the capital, which is adjusted for fees, is returned to investors. Alternatively, after the IPO the acquisition can be completed and the acquired company revealed. Investors will get an equity stake in the company proportionate to their capital contribution. 

Benefits of SPACs

One of the main advantages of SPACs, and unlike a traditional IPO, is that they reduce the time required for a company to go public. Typically, it could take a few months for the target company to go public whereas a conventional IPO may require a year. 

SPACs could also be marginally more cost-efficient than classic IPOs. SPACs have proved to be a very successful way of making companies public as new issues have risen from 59 in 2019 to 444 in 2021, or more than a 700% increase, and reached a market share of 59.4%. 

Another advantage of the SPAC is that it may receive increased public attention if its sponsors are prominent and reputable business executives or financiers. 

Risks Associated With SPAC

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Scarce Regulatory Oversight 

These entities aren't subject to much regulatory oversight compared to traditional financial institutions. However, there is a difference between U.S. and European markets regarding SPACs - the special purpose vehicles have been more integrated in U.S capital markets than in their European counterparts. The closest to a U.S-like regulatory regime is the Netherlands'.

Further, the initial capital required for an investment in a SPAC is €100,000 in the Netherlands while in Paris the minimum is ten-fold - €1,000,000.

Europe's Alternative Investment Fund Managers Directive is likely to add a layer of regulation over SPACs which could deter investors and slow down mergers & acquisitions (M&A) deals. This could result in M&A activity shifting more towards the U.S.

Insufficient Disclosure on the Target Company

In a certain manner, a lighter version of a traditional IPO, the SPAC is not obliged to provide information on the target company. Neither is it required to supply audited financial statements for both the target company and the SPV. Investors take a leap of faith in the management by trusting them that the acquisition will be successful. 

Regulation and disclosure requirements could alleviate risks posed to investors and create more transparency. 

Returns can experience wilder swings and volatility can be heightened relative to an index. 

The S&P U.S. SPAC Index, launched on 23rd August 2021, provided a better risk/return ratio in the short and mid terms over the S&P Small Cap 600.

Dilution Risk

When investors invest in SPACs they purchase units that contain shares and warrants, sometimes fractions of warrants. A warrant is usually set at $11.50 and a share - $10. Warrants are contracts that give investors the right to purchase a specified number of shares in the future at a specific price. The price is usually a premium to the stock price when the warrant was issued. 

An important element to be vigilant about is the redemption period. The redemption period is simply the deadline to exercise the warrants. Once the deadline has passed, warrants are no longer redeemable and they expire (almost) worthless. Detailed information on warrants, including the redemption period, can be found on EDGAR, the SEC database platform.

However, if the stock price is above the warrant strike price, issuing additional shares as a result of exercising the warrant, creates dilution. In addition, bank and broker fees are paid in shares.  

The dilution risk also takes into account the fact that founders receive 20% of the total SPAC shares without necessarily a capital input from them. The shares of the founders are known as the "sponsor promote". 

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Special investment vehicles are structured products that are particularly useful for hedging risk, ensuring liquidity and offering investors more tailored solutions that meet specific investment objectives in terms of risk and return. However, these entities and particularly collateralized obligations may pose risk management challenges as their complex structure is more difficult to estimate regarding creditworthiness. A buoyant approach and relative laissez-faire regarding the issuance of those instruments could be severely impacted in the event of negative credit circumstances.

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