The Unravelling of Structured Investment Vehicles

Few were familiar with the $400bn, 20-year old structured investment vehicle sector in summer 2007 when it gained notoriety for sudden defaults and multinotch downgrades by credit rating agencies.

SIVs were hybrid companies that combined features of traditional banking, hedge funds and securitisation. They borrowed short mainly from money market funds, and lent long to banks and securitisation issuers, employing leverage to amplify profitability. They issued long-dated hybrid capital comparable to bank subordinated debt. Like securitisation transactions, they were bankruptcy-remote and operated under tight limits.

At the pinnacle of their success, SIVs were the Rolls-Royce of modern finance - efficient machines equipped with smart, risk averse managers. Most reputable institutions established or considered sponsoring SIVs. Rating agencies featured long pipelines and SIV analysts were at a premium.

The run on SIV-lites

SIV-lites were abridged versions of SIVs with predominantly mortgage-backed assets funded with shorter-dated liabilities.

In mid-2007, two hedge funds sponsored by Bear Stearns became distressed. The bank announced precipitous asset value declines and complained that prices did not reflect fundamental value. Some of the funds' assets were similar to those of SIV-lites and their lenders included institutional sponsors of SIV-lites. The stage was therefore set for a run on the sector; this occurred in summer 2007 as money market fund investors exited in droves.

M-LEC - too little, too late

The US Treasury, keen to avoid money market fund defaults, tried to establish the ill-fated Master Liquidity Enhancement Conduit (M-LEC). The conduit would have purchased SIV assets and injected liquidity into the sector. M-LEC was therefore intended as a belated lender of last resort to SIVs.

The plan proceeded slowly and was too little, too late. The implementation delays reflected, in part, inadequate analytical resources and poor understanding of SIVs.

Such resource constraints seemed a common theme amongst governmental agencies and regulators, notably the Federal Reserve, the Bank of England, the FSA and even the Bank for International Settlements. They all began their SIV education when the requirement seemed decisive action as implemented for banks.

Regulators and central bankers were joined by rating agencies in misjudging the speed and ferocity of the crisis. The agencies even appeared in competition for meteorological metaphors to calm investors' nerves. In July 2007, Moody's reported that the sector was a "calm oasis". Standard & Poor's followed a month later with a claim that its SIV ratings were "weathering current market disruptions". Vehicle implosions and multinotch rating downgrades began only a couple of days after Standard & Poor's report.

Liquidations, lawsuits and bailouts

Forced liquidations and lawsuits followed vehicle collapses. Entire portfolios were offloaded in fire sales that generated losses of 60%-95% for senior investors. Courts in New York and London were called upon to interpret convoluted and conflicting clauses in legal documentation, exacerbating the pain for investors who had hitherto believed their top-rated securities to be near-bulletproof.

Some cases filed in 2007 and 2008 were not concluded until mid-2010, while a case involving the largest vehicle, Sigma Finance, became one of the first to be heard by the newly constituted UK Supreme Court. Major sponsors bailed out their vehicles' senior investors to prevent reputational damage, leaving vehicles that did not enjoy strong sponsorship to default on their debt.

Complexity and opacity masked deeper causes

Complexity and opacity were the first explanations proposed by market participants for the sector's troubles. Indeed, SIVs were among the most complex of companies as suggested by their membership of the infamous alphabet soup club of structured credit products. The sector was also widely perceived as opaque in its operations and lacking in disclosure to investors and rating agencies.

The difficulties subsequently faced by other less complex and supposedly more transparent market segments such as money market funds, investment banks, monolines, commercial banks, sovereigns and sub-sovereigns demonstrated, however, that the SIV's demise had deeper causes.

Macroeconomic and systemic causes

SIVs were a product of the liquidity bubble that began engulfing the credit markets some 20 years before their demise. This period happens to coincide with the sector's lifespan. Trade surpluses from savings economies and petrodollars from oil-producing nations led to a significant reduction in the global cost of credit. Ordinarily risk-averse investors in search of high-yielding products settled on SIV paper as an attractive alternative to US Treasuries.

Banks searching for new ways of generating incremental revenue set their sights on SIV management fees. Subordinated debt investors saw SIV capital notes as a means of earning steady returns in a market-neutral environment supported by highly rated and well diversified portfolios. The agencies earned fees estimated at a staggering $175m to $200m for rating and surveillance activities during the sector's lifetime. The SIV therefore seemed a resilient winning model for all. This view was enhanced by the sector's effortless weathering of seemingly severe historic market disruptions.

Bubble fever

SIV actors showed some of the classic symptoms of bubble fever - complacency and hubris. While a run on the sector and simultaneous drops in asset values were possibilities, invoking such a spectre invited refrains from seasoned professionals of the availability of funding alternatives and the impossibility of a protracted debt market freeze. Practitioners further relied on supposedly liquid assets to generate funding in the event of a crisis. These responses seem characteristic of a bubble mentality. Key actors appeared too engrossed in the revenue imperative to perceive the burgeoning credit and liquidity bubbles.

Risk management and regulatory failures

Risk management requires identification, measurement, aggregation and effective management of risks. It should help businesses allocate sufficient capital for survival and growth. The SIV's extinction highlights risk management failures by the vehicles, their sponsors, rating agencies, policy-makers and regulators.

Regulators permitted sponsors to establish SIV "mini-banks" without ensuring they maintained sufficient capital and back-stop liquidity in the event of a run. Policy-makers also seemed unaware of the knock-on effects of the SIV's demise on the securitisation and credit markets.

Lessons to be learned must therefore include the tightening of regulations governing sponsorship of off-balance-sheet structures and the sizing of their capital and liquidity needs. Lessons learned must also include in-house retention of risk-analytical capabilities by investors, and less reliance on credit rating agencies which, as the crisis demonstrated, are far from infallible.