SIVs and SUVs |
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| Written by Rick Tobin | |
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Our national and international economies are affected greatly by the two acronyms listed above in the title (SIVs and SUVs). Each acronym represents the following words. “SIVs” are the initials for Structured Investment Vehicles, and “SUVs” are the initials for Sports Utility Vehicles. One of these helps “drive” the credit markets, and one of these you drive on the road.
The two acronyms help represent what is going on in today’s world economy. They also help me explain the current state of our capital and credit markets as well as why energy costs are reaching all time record highs.
Let me try to explain and hopefully simply this complex arrangement. Let’s begin with SIVs and their impact (both positive and negative) on the latest “credit crisis” to hit our country.
The first step in the process of creating paper to be sold off in the secondary markets begins with property owners taking out mortgages to buy or refinance their homes. Shortly after the loan is funded, most banks or mortgage companies sell off the loans in the secondary market. If banks or mortgage companies don’t sell off enough loans in the secondary market, then they may run out of capital to lend in the future. The purchaser of these loans in the secondary market may then, in turn, package the mortgage loan within a “pool” of several hundred other mortgage loans based upon similar criteria (i.e. FICO credit scores, property types, or comparable underwriting data).
Many of the “pools” of packaged Mortgage Backed Securities (MBS) are sliced into “tranches” with various levels of credit risk. The different levels of credit risk are named Collaterized Debt Obligations (CDOs). The three largest Credit Rating Agencies (i.e. Moody’s, Standard & Poor’s, and Fitch) then rate the potential risk of these bond investments as AAA (the highest and safest rating) or below. Many of these CDOs were rated as AAA, which is considered as safe as an investment in a U.S. Treasury Bond.
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The major bond rating agencies may have issued over inflated ratings on billions of dollars of securities backed by mortgage pools and other types of secured or un-secured credit. Traditionally, financial ratings should be based upon true market value and actual market prices. The bond ratings on these CDOs were considered as if these artificially created securities had fairly liquid markets. These investments rarely had firm price bids and could never be properly valued. The bond ratings were issued for these CDOs as if they had fairly “liquid markets” (or that they may be sold quickly for fair market cash). CDOs are fairly illiquid or difficult to sell for cash as there are only so many buyers for these types of investments.
The higher the rating by the bond agencies, then the lower the rate or yield paid out to investors. AA, A, BBB, or below ratings are considered riskier investments so the rates or yields tend to be higher to investors. As delinquencies for some of the home mortgages across our nation increased, the investments in these CDOs have begun to lose money. As a result of substantial losses, the three major Credit Rating Agencies have been forced to downgrade their credit ratings for these investments due to the increased risk (potentially over $80 billion may be downgraded).
Many of the largest investors in CDOs over the past several years have been large pension funds, institutions (i.e. universities, etc.), and money market funds. Each of these major entities may control billions of dollars each. They are bound by a fiduciary investment covenant to sell any securities which are below a certain investment rating level (i.e. AAA or AA). As a result, there are more sellers in the marketplace today than buyers. With less demand for these investments, some of these prices have fallen substantially. With more CDO defaults, the bond rating agencies may downgrade these investments to “junk status”. If the bond ratings decline, then there may be more sell-offs and larger declines in the CDO’s values.
This leads us to a brief explanation of Structured Investment Vehicles (SIV). SIVs were created in the mid-1980s by several large banks and investment managers for the purpose of generating leveraged returns by taking advantage of the differences in yields between the longer-dated assets and the short-term liabilities issued. SIVs use short-term funding like asset-based commercial paper to purchase longer term assets (i.e. mortgage backed paper). Many banks or Wall Street investment firms use the SIVs in the form of “off balance sheet” structured investments. This means that many of our largest financial institutions are not reporting their significant gains or losses from their SIV investments. This is a major reason why the credit markets “froze” as it is very difficult to determine the true value of these investments right now.
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