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How did SIV rise so quickly on the eve of the financial crisis?
In the late 1990s, Structured Investment Vehicles (SIVs) emerged in the market as non-bank financial institutions and quickly attracted the attention of investors. They mainly raise funds by issuing short-term liabilities and then invest the funds in longer-term, high-yielding assets in an attempt to earn interest rate differentials. This operating model has created a lot of profits for investment institutions and triggered major changes in the financial world.
At the heart of SIVs is the spread between raising capital and investing, which allows them to apply their capital for long-term investments without being exposed to interest rate or currency risk.
Since SIVs are usually established as offshore companies, they avoid the tax and regulatory issues faced by banks, further attracting a large number of investors. These institutions are labeled as part of the "non-bank financial system". Before the outbreak of the financial crisis, the number and asset size of SIVs grew rapidly, even reaching approximately US$400 billion in assets under management at their peak in 2007.
Historical background of SIV
SIV’s history dates back to 1988, when two investment vehicles called Alpha Finance Corp. and Beta Finance Corp. were first launched by Citigroup bankers Nicholas Sossidis and Stephen Partridge-Hicks. Their innovation has made SIV a popular investment option in the financial markets.
"Alpha Finance was created in response to the volatility of the capital markets at the time. Investors needed a highly rated instrument that could provide more stable returns."
Over time, the success of SIV attracted more similar institutions to enter, and total assets in the market actually tripled between 2004 and 2007. However, this boom did not last long, and by 2008, the global financial crisis caused all SIVs to declare bankruptcy.
How SIV works
SIV raises funds by issuing commercial paper (CP) and medium-term notes (MTN), which are used to purchase long-term assets such as mortgage-backed securities (RMBS), corporate bonds, etc. The yield on these assets is typically higher than the cost of their liabilities, creating a spread. Although this model seemed quite successful before the crisis, it actually had potential risks.
SIV's operating model is basically the same as a traditional credit spread bank, but its leverage operation is significantly higher than that of many traditional banks, making it relatively vulnerable in the pursuit of profits.
Prelude to the financial crisis
As the U.S. subprime mortgage crisis intensified, SIV, which invested in subprime mortgage loans, experienced heavy losses. Although most SIVs have tens of billions of dollars in assets under management, when risk sentiment picked up, the market's assessment of these assets quickly deteriorated, liquidity crises began to occur in the liquidity market, and the difficulties faced by SIVs gradually emerged.
During the financial crisis, SIV's asset valuations fell rapidly, which prevented them from renewing new notes to repay maturing liabilities as usual, leading to a collapse of the entire market.
Although SIV itself is not directly involved in the assessment of mortgage loans, compared with traditional bank credit risk management, its risk assessment often relies too much on statistical models, resulting in insufficient understanding of market downside risks. This becomes even more apparent during market crashes.
Potential issues with SIV
In the entire operation of SIV, inherent risks include liquidity risk and credit risk. In the event of increased market instability, a SIV may face the risk of a decline in the value of its assets, which will further affect its ability to repay short-term liabilities.
“A large number of SIVs ultimately led to the collapse of the entire structured financial system when they failed to effectively assess the risks in their portfolios.”
As times change, the rise and subsequent collapse of SIV has become a microcosm of the complexity of financial markets and a warning to uphold greater transparency and risk control in future financial innovation. The financial crisis not only changed the operating model of the banking system, but also redefined investors' understanding of risk. How will the future financial world avoid making the same mistakes and achieve more sustainable development?
