The Role of Structured Investment Vehicles in the Recent Financial Crisis

First, news that liquidity problems in the financial sector are continuing followed by an explanation of why the crisis is so widespread:

ECB and Fed intervene in money markets, by Ralph Atkins  and Michael Mackenzie, Financial Times: The European Central Bank and the US Federal Reserve intervened in the money markets again on Thursday, with the ECB injecting €42.2bn and the Fed adding a total of $31.25bn into temporary reserves, more than market participants had expected. ...

The operation, making extra cash available for one day, followed a surge in overnight interest rates this week that has set back the ECB’s hopes that conditions in money markets were normalising. ...

Update: The WSJ Economics blog says:

Level of Outstanding Commercial Paper Falls, by Anusha Shrivastava : The outstanding level of commercial paper dropped again in the latest week, but a smaller decline relative to previous weeks suggests the credit crunch in short-term debt markets isn’t getting worse.

The bulk of the decline in the week ended Sept. 5 was in the asset-backed commercial paper segment, where investors have proven most reluctant to finance companies’ short-term borrowing needs due to the subprime mortgage contagion in that area. ...

Thursday’s data shows that “while tensions remain elevated, conditions may not be getting worse,” wrote Marc Chandler, currency strategist at Brown Brothers Harriman, in a note.

This paper looks at a puzzle about the crisis, how the relatively small value of the defaults in the subprime market turned into such a widespread crisis. The argument is that structured investment vehicles (SIVs), which borrow short and lend long and are hence subject to liquidity problems, provided a conduit through which risk that was supposed to be diversified away unexpectedly returned to banking intermediaries and led to more systemic problems. A summary:

Securitisation transferred credit risk from bank’s balance sheets to the market. The subprime problem became a crisis when some of this risk landed back on banks. Regulators need to find a way to deal with the off-balance sheet operations of banks that made this possible and to improve transparency concerning banks’ effective exposure to risk.

And the paper [Update: Jim Hamilton has a nice discussion of "the nature of current problems in financial markets" in Borrowing Short and Lending Long that complements and extends the following discussion]:

Subprime crisis and credit risk transfer: something amiss, by Luigi Spaventa, Vox EU: By now everyone in Europe knows all about American subprime loans – ranging from “Alt-A” to the “ninja” variety (granted with “no verification of income, job status or assets”). Still, it is not obvious why an even pronounced increase in delinquency rates on such loans, with the attendant losses on mortgage exposures, should have sparked a financial crisis that touched all classes of assets globally, even those relatively immune from credit risk. True, the share of the less safe loans in the issuance of mortgage-backed securities had almost doubled in the past few years. But an estimate of the direct losses of the actual and expected defaults ranges between 100 and 200 billion dollars – relatively little, considering the valued of aggregate of financial assets (and also in comparison with the 5 trillion dollars lost in the dot.com crisis).

We know how the crisis has unfolded[1]. After a sharp drop in the prices and market liquidity of all mortgage-backed securities, an equally sharp increase in the price of risk and in spreads, and a drying-up of the issuance of all asset-backed securities, contagion extended to the short-term end of the financial market – first to a wide class of commercial paper and then to the money and interbank markets. As uncertainty and mutual mistrust spread to counterparties (even banking counterparties), overnight interest rates jumped and, as they say, cash became king. The repeated injections of liquidity on the part of various monetary authorities have so far provided only limited solace to this state of affairs. All this is clear, but the question is: Why should a surge of subprime defaults affect (though not disruptively for the moment) the banking system and (more worryingly) general credit conditions?

The question arises because the subprime mortgage-backed securities that sparked the crisis represent an extreme version of the credit risk transfer process in which the core banks have been engaged for a long time pursuing the “originate and distribute” business model. The banks originate the loans and then distribute the underlying risk to a myriad of outside investors. This made credit “something that is largely bought and sold on the markets, rather than held … on the balance sheets of financial intermediaries”[2]. Among the undisputable merits of this model (more complete markets, a wider range of instruments available to investors, enhanced liquidity, improved allocation of resources) is that the transfer of credit risk away from banking intermediaries would make the system more resilient to financial shocks. The fragmentation of risk and its distribution to non-bank players providing liquidity in several markets would alleviate the systemic consequences and allow an easier absorption of such shocks. This, however, is not what has happened. Though the credit underlying all kinds of asset-backed securities and of credit derivatives should no longer be on the balance sheet of the originating banks, the collapse of one segment of those securities has affected and is affecting the banking system. Why is that? The answer is that part of the credit risk flowed back to some banks, though not on to their books.

This has mostly happened through the growing diffusion of “conduits” and structured investment vehicles, widely know as SIVs[3]. These are entities, off the banks’ balance sheet, that invest long-term, largely in high-yield asset-backed securities, and raise short-term finance by issuing correspondingly collateralized commercial paper (so-called asset-backed commercial paper). The banks provide such entities with financial guarantees that only appear below-the-line in their balance sheet, playing the role of last-resort liquidity providers if and when difficulties of refinancing arise. The precise extent of such commitments in the aggregate and for individual banks is unknown. According to market estimates reported by the BIS outstanding asset-backed commercial paper reached a sum of $1.5 trillion last March, of which some $300 billion was based on mortgage-backed assets. According to another estimate, European banks have more than $500 billion invested in asset-backed-commercial-paper conduits with German banks holding a quarter of this sum.

As the prices and market liquidity of the collateral collapsed, refinancing by rolling over the outstanding commercial paper has become almost impossible. This is why the committed banks and financial institutions have been required to provide emergency liquidity. In this way, some of the credit risk that was transferred to the market by the banking system has re-emerged on the banks’ books, straining capital requirements to an extent depending on the size of the commitment relative to the assets of the bank. Two small German financial institutions (IKB and SachsenLB) found themselves exposed to their vehicles to such an extent, that they had to be bailed out with emergency rescues. The position of bigger banks, with more solid capital positions, has obviously not reached anything near a critical stage, but the suspicion of hidden difficulties infects the market. The problem is compounded by the fact that when the credit risk transfer mechanism froze in August, some core banks which arranged bridge financing for important private equity operations found it impossible to pass on the risk as usual. They are now unable to securitize and transfer the credit that they granted on the eve of the crisis (to the tune of over 200 billion).

The next question is: Were regulators aware of this roundtrip of credit risk (from banks to market and back to banks)? Hardly, one is tempted to answer. First, the official literature (central banks’ financial stability reports, Bank of International Settlements reports, papers of the Financial Stability Forum) shows that regulators were indeed worried by the vulnerability of the system following a change in risk appetite and in market liquidity conditions, but also that most of their attention was addressed to hedge funds as the banks’ riskiest counterparties. This is that source of the widespread recommendations that banks should obtain greater information on hedge-fund positions and improve counterparty risk measurement and management when dealing with them. I may be wrong, but I could find no mention of the potential problems arising from the existence of off-balance sheet vehicles sponsored and guaranteed by the banks. Second, only in the past few weeks have supervisory bodies been hastily inquiring on the exposure of individual banks to such vehicles. Supervisors have puzzled over the problem of where the credit risk ended up. Little did they know, apparently, that a chunk of it had returned where it came from.

This crisis, however it ends, is likely to prompt ill-conceived regulatory proposals. But, if there is one field where something ought to be done, even before damning the sins of rating agencies, it is to find a way to deal with the off-balance sheet operations of banks and achieve greater transparency of their effective exposure to risk.

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Footnotes

[1] A useful rendition of the events since June and up to August is in Bank of International Settlements, BIS Quarterly Review, September 2007. Also see the Vox columns on the subprime crisis.
[2] Mario Draghi, “Monetary Policy and New Financial Instruments”, Central Bank of Argentina – 2007 Money and Banking Conference.
On which see BIS Quarterly Review, cit and Stephen Day and Agnes Molnar, “Investment vehicles: The advantages of flexibility”, International Financial Law Review, November 2006
[3] Ivar Simensen and Ralph Atkins, “’Not uncritical’: Subprime exposure drags down German banks”, Financial Times, August 22, 2007,

Comments

[calmo]

It's tuff (totally, utterly ffrustrating) to keep up with all the acronyms that are generated by the financial community (a subset of the economists community, in the marine sense of the word) [clients to the financial community (newly coined "sheeples") need to get their acronym generators tuned up and start lobbing back] but this one makes me smile: SIV.
I name my cars (so did your parents ["ol Betsy"] and you snickerers might try it an see if it doesn't reduce repair bills) and I am tempted to change from "The Lam" (short for Lamborghini) now that it (a collectible Toyota van) has proved itself as a structured investment vehicle...compared to your Fiesta for instance.
But they say its bad luck and frankly, it just doesn't sound as good, you know?

[Mark Thoma]

Maybe "Structured Home Investment Vehicles"?

Was this the SHIV?

[jck]

Perhaps the professor from voxeu should ask the right question: why is there so much "securitization"?
the inept piece regulation called "basel 2" is the answer.

[Mark Thoma]

Yes, Basel puts me to sleep, but it's important. David Wessel at the WSJ had something on this:

http://online.wsj.com/article/SB118842768442912725.html

[Winslow R.]

"supervisory bodies been hastily inquiring on the exposure of individual banks to such vehicles. Supervisors have puzzled over the problem of where the credit risk ended up. Little did they know, apparently, that a chunk of it had returned where it came from..... if there is one field where something ought to be done...it is to find a way to deal with the off-balance sheet operations of banks and achieve greater transparency of their effective exposure to risk."

Of course, more of the same. Let's 'fix' the system so that banks and their tainted ways never try to become opaque again. Dumb.

Fannie Mae has proven banks are not needed for financing. How long before it is discovered they are not needed as depository institutions?

The government should shift the FDIC onto a public entity where the public can put their deposits free from this ilk.

Let banks become nonbanks, free from most regulation yet wholly responsible for their own actions. Isn't it obvious by now?

[jck]

Thx, Mark.Had missed the David Wessel article.

[calmo]

Some huge thoughts from Winslow (calmo busy with eraser on preconceptions of Winny as conventional nit-picker) and, wait up for me, not it's not obvious.
This, I believe qualifies as Plonking Type I:

The government should shift the FDIC onto a public entity where the public can put their deposits free from this ilk.

and chases me to the fridge for a beer. It sounds so good, it might as well taste good too.

[KnotRP]

If $1 equity is used with $9 borrowings to buy an asset
class that's generally being chased up in price by leveraged
money, and the only collateral for that $10 is the asset
being chased (no other verified assets or income), and
on top of that, the "deal maker" takes $2 and 20% of the
price rise on the way up, one has to say the result is
not suprising or unexpected.

Mean reversion
Margin Call
100% equity loss
Lender in possession
Distressed asset sale

Another generation of greater fools are harvested.
Rinse. Lather. Repeat.

[STS]

The pun which occured to me was SIV pronounced seive. As in; this structure leaks like a SIV. Seives aren't notable for their ability to hold liquid(ity).

[calmo]

Ok...this one makes me and STS smile: SIV.

[prostratedragon]

Among college ice hockey fans, a popular jeer at a visiting goalie whose fumblings have delighted the home ice crowd is

Sieve! Sieve! Sieve!

which is what those SIV things keep reminding me of.

(Let's see, where have we heard the borrowing short-lending long blues before? Oh yes, those S&L yokels 20 years ago! Time to tune up for a chorus of Invierno Manahatta...)

[KnotRP]

$2 should be $.2, but the point remains.

[Winslow R.]

Calmo wrote: "plonking Type I" : a little wild-eyed obfuscation

Perhaps - as I try to come at this 'bus' from every possible angle.

New angle: challenge the need for private depository institutions insured by the FDIC.

How can we the people protect our money from physical loss?

Mattress, box in the backyard?
Crazy to receive no interest.

Bank, credit union, brokerage account?
Crazy to risk depository institutions squandering it away on faulty investments without some type of government insurance.

Government, Fed reserve?
Crazy to make banks compete with the rest of the private sector and the public sector for reserves.

Or is it?

We already have such a mechanism, long-term treasury bonds and no one complains about those. (Well, a few do.)

Why not expand the government ability to accept overnight deposits, 1 day instead of 30 days. Is this so hard?

The Fed already runs the ACH. Checking accounts would be no problem. It would allow much tighter control of the money supply without becoming a leveraged mess. Turn banks into nonbanks, a natural evolution.

http://en.wikipedia.org/wiki/Automated_Clearing_House

[dd]

Subprime is the cover. Been there done that. Does anyone really believe anything that is coming out of investment banks? Jeesh, they gave us dot bomb, off-balance sheet investment vehicles, Enron, World Com, mutual fund timing scandal, Refco/Amareth blowup, derivatives, structured investment products, CMOs, CDOs, credit swaps, securitization, ABCP & my personal favorite: constant proportion debt obligations that piggyback CDS. Innovation is great; but this isn't innovation; it's the Equitable I (1904) and II (1988) redux (insurance cos the original nonbank bank and now folded into IB....a really bad idea).
The ratings agencies are a distraction as were the Enron accountants. IB better get its act together and fast as liquidity will continue to dry up as the important pension investors understand they are no different than the rest of the sheeple.

[calmo]

Thanks Winslow (and to be called a Plonker, esp a type I Plonker is intended as the highest compliment) for this:

Turn banks into nonbanks, a natural evolution.

I am digesting it, slowly, sitting down (someone has to --now that you are skipping around, you know?)

[Brenda Rosser]

There's a good overview of the history of the emergence of uncontrolled finance capitalism here:

Credit Bubble Bulletin, by Doug Noland
http://www.ldusa.com/roger/doug_nolan.htm
Contemplating the Evolution From the Way We Were to The Way It Is
June 13, 2003

I am trying to obtain an idea of how these structured finance products came into being and a quick idea of how they work. So far I can glean that they, in fact, don't work and the result is what is evolving now in the global financial markets and the global economy in general.

Greed. A lack of ethics/morality. No effective democracy in place - two parties easily purchased. A corporate press unable and unwilling to provide safeguards against the foxes guarding the chickencoop (on account of their affinity with foxes).

"When a government is dependent upon bankers for money, they and not the leaders of the government control the situation, since the hand that gives is above the hand that takes. Money has no motherland; financiers are without patriotism and without decency; their sole object is gain."
Napoleon Bonaparte

[Farrar Richardson]

It is incomprehensible to me as an ex banker that a bank's contingent liabilities for SIV's are not taken into consideration when judging their capital requirements. Doesn't the Fed, the comptroller of the currency, the FDIC or SOMEBODY examine banks any longer ?

[Farrar Richardson]

Interesting discussion of Basel II, but it is still not clear to me whether bank's contingent liabilities in the form of their guaranties of SIV's obligations are subject to reduced capital requirements, no capital requirements, or what. Maybe no one else knows either, and that is the problem.

[Winslow R.]

Brenda Rosser wrote: "Money has no motherland; financiers are without patriotism and without decency; their sole object is gain."
Napoleon Bonaparte"

Just shows how times have changed but not far enough. Fiat currencies do have a motherland, and the Fed, an extension of government is now the hand that gives. The hand that gives is still hampered by its tight connection to banks.

Banks retain their grip on giving because they are supposed to be the firewall to corruption of the money making process.

The counter examples to corrupt banks are always of corrupt governments gone awry. I think this is a false counter as banks have no real part to play.

It is in 'our interest' that 'our money' retain value.

What so many have yet to accept is that banks work against that interest, not for it as they are profit seeking entities not working for 'our interest' but their own.

This misalignment of 'interests' in the fiancial system still needs to be addressed.