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What are SIVS and what are they doing to our financial markets?

A new breed of investments has introduced much more risk into the markets, says this advisory, and there may be more trouble ahead.

Most of the trouble we have seen in the credit markets and the stock markets over the past few months has been caused by something called an SIV.

Oh boy, one might sigh, another set of initials to contend with. What does this one stand for? It sounds a bit like something you could drive on dirt roads. And in fact, it is a vehicle — a structured investment vehicle.

SIVs represent a major shift in the way financial institutions are doing business. And it’s not necessarily a shift for the better, says Review & Outlook, a Boston advisory put out by a firm that is in the money management business.

Big financial names, from Wall Street to Bay Street to the capitals of Europe, have already been shaken by the tremors from SIVs. There are liable to be more.

SIVs are “not exactly a household name,” says this advisory, “but it is important to note that these vehicles have permeated the financial system in recent years and have been extremely profitable for the originators, which are often large multi-center banks.”

In a way, adds the advisory, these vehicles are simply a variation on the carry trade. Basically, that means borrowing low-yielding currencies, lending high-yielding ones and profiting from the spread.

Offshore and unregulated

SIVs borrowed money in the short term in order to invest in higher-yielding or more risky assets longer term. They have been put together by banks such as Cititbank “through offshore and often unregulated facilities, and then sold to wealthy investors and hedge funds for their high yield.”

The most notorious of the investments bundled into SIVs were the subprime mortgages that have come tumbling down in recent months. But, says the advisory, these made up only a “tiny part” of the funds created.

“It should be emphasized that all kinds of asset-backed securities typically filled the buckets of these vehicles, with varying degrees of risk and transparency,” states the advisory. “High fees were charged by the people putting the funds together and, of course, hedge funds could presumably offer their clients good returns provided that game could continue.”

No such luck. Things began to unravel in August (the near-collapse of two large Bear Stearns hedge funds starting the deluge), and liquidity for people who were funding SIVs dried up.

The worm at the core

And here’s the worm at the core of the apple. SIVs were essentially “off-balance sheet” vehicles that permitted banks to be exposed to a series of complex asset-backed securities “without really having any reserves to back them up.”

Even though many SIVs were operated by banks, had banks as investors or even had provisions allowing them to call on bank financing when their own sources of liquidity dried up, “they were not technically on the banks’ balance sheets.”

In short, even the most diligent survey of quarterly reports would not have turned up a trace of the investment vehicles that are currently eating away at the reserves of major financial houses on Wall Street, Bay Street, the City of London, Paris, Frankfurt and even Switzerland, for heaven’s sake.

A case in point is the Royal Bank of Scotland. A little less than a month ago, a small SIV managed by a hedge fund known as Cheyne Capital defaulted. This one was heavily involved in mortgages.

The most curious aspect of this was that the hedge fund still had a “good amount of cash on the balance sheet,” yet a U.K. court declared it in breach of solvency tests. It had to be reorganized or liquidated. The bank behind Cheyne — the Royal Bank of Scotland — is still trying to sort the mess out. Meanwhile, the bank’s shares have been driven down 20 per cent in the past month. (Indeed, a crisis of confidence on the British markets earlier today is one of the reasons the U.S. dollar has regained some vigour while the pound and the loonie have slipped back.)

The question is: will this sort of shape-up-or-ship-out ultimatum be issued to other SIVs, setting up a chain reaction of failures?

A toad into a prince

In order to prevent just such a reaction, U.S. authorities are proposing a rather large safety net — a $100 billion bailout fund. It would be known as a Super SIV, or, in a wonderfully dense phrase, a Master Liquidity Enhancement Conduit (MLEC). In this case, the initials are easier to grasp than the words they stand for.

Names aside, this super fund would be fronted by four large American banks. Its mandate would be to prevent smaller SIVs from having to unload their assets at distressed prices. All the participants would have to use market prices to rebalance and reprice their own SIVs.

“The problem with the Super SIV fund,” reasons the advisory, “is that it is probably only going to buy the most creditworthy notes from other SIVs, thereby giving them some liquidity, but leaving them with what is known as ‘toxic waste’.” That means there will still be lots of bad debt lurking in the financial system

One of the most telling comments on this flawed system of investing came, not surprisingly, from the world’s most famous investor, Mr. Warren Buffett, on a recent trip to Asia:

“One of the lessons investors seem to have to learn over and over again, and will again in the future, is that not only can you not turn a toad into a prince by kissing it, but you cannot turn a toad into a prince by repackaging it.”

Those comments, according to the advisory, “echo the sentiments of many, including ourselves, who simply believe we have entered an extremely high-risk period in credit markets.”

A shadow banking system

SIVs effectively represent a “shadow” banking system. “It will have to undergo even greater scrutiny in the coming weeks and months,” claims the advisory. First we build up a regulatory and supervisory system led by organizations such as the Central Banks, the Bank of International Settlement in Basel and others, then we allow large multi-center banks to circumvent them.”

The financial community has reinvented complex ways to “essentially borrow short and lend long,” adds Review & Outlook, and “all of this has been accomplished under the very noses of the regulators, who as Alan Greenspan recently stated, ‘seem not to have caught up with some of the advanced products available’.”

Not only that, “the pricing of these vehicles is so highly dependent on mathematical modeling as to make it incomprehensible to all but a few advanced PhDs.” And the “models” created by the said eggheads “are based on past volatility which is simply not operational when extreme events occur.”

The obvious question is: What next? Are the troubles at Merrill Lynch, Citigroup and others merely the tip of the iceberg? Insurance companies, savings and loans firms and others are being dragged in. We have seen big Canadian banks take large writedowns.

“All of this is likely to get worse,” warns the advisory. The original credit ratings of SIVs were, it is now admitted, much too high and they are being progressively downgraded by Moody’s and Standard & Poor’s. SIVs that were previously AAA are now trading at 80 cents on the dollar.

“For now we remain vigilant,” concludes the advisory. “We prefer to sit on the sidelines as far as the financial stocks are concerned, believing that few bargains are available.”

Caution is the watchword. The imprudent vehicles of financial insiders and the deep-pocketed investors they attracted can still do a good deal of collateral damage to ordinary investors who have done nothing more than mind their own business.

We’ll give the last word to the advisory: “Frankly, we are not seeing any attractive toads out there, and even if we did, we would not be kissing them just yet!”