Tuesday, 13 November 2007

Making sense of SIV's

SIV's or Structured Investment Vehicles have been thrust into the limelight as one of the main culprits in the latest round of credit market turmoil.

Essentially SIV's are entities used by banks to invest in long-term assets by borrowing short-term in the commercial paper market. The bank earns a fee for managing the SIV, but can keep the SIV's debt off the balance sheet because it doesn't take on the credit risk. However, many banks agreed to provide liquidity in the event that an SIV cannot roll over it's Commercial Paper.

The problem now is that noone wants to touch the Commercial paper that SIV's have been using to fund themselves because the assets they have been investing in are declining in value and now the always late to the party ratings agencies are downgrading them.

just how bad is the decline in value of these assets held by SIV's? According to a New York Times piece yesterday:

Prices vary, but even amid a deteriorating market, some analysts say that the bulk of SIV assets are still fetching between 97 cents and 98 cents on the dollar.

97 - 98 cents on the dollar doesn't sound too bad, but that;s just half the story. The other half is the massive amount of leverage the SIV's have employed. From Calculated Risk:

.... Fitch rated SIVs average 14 times leverage. So, if an SIV had $1 Billion in capital, and an additional $14 Billion in leverage (mostly from selling commercial paper and medium-term notes), the SIV would hold $15 Billion in assets. If the typical asset was "fetching between 97 cents and 98 cents on the dollar", that would be a loss of $300M to $450M, or a loss of 30% to 45% of capital (from the $1 Billion) giving a NAV of 55% (97 cents on the dollar) to 70% (98 cents on the dollar).

According to Fitch, if the NAV for an SIV falls below 50%, then the fund might face an enforcement event, and it might have to be liquidated. Once the assets of one fund were liquidated - say at 96 cents on the dollar - that would mean the NAVs for other SIVs would probably fall below 50% - and they might also have to be liquidated, further depressing prices.

That about says it all. Good old leverage is great on the way up but disastrous on the way down. A loss of 2 - 3 cents on the dollar can result in huge reductions in the NAV's of SIV's. The process of forced events feeds on itself into a vicious downward spiral.

Now you can understand all the fuss about the super SIV bailout fund being touted by, Henry subprime is contained Paulson. However even Paulson seems to have lost some enthusiasm for the proposal or at least he has had to take a does of reality about what it will actually achieve. Again from the New York Times:

Officials from Bank of America, Citigroup and JP Morgan Chase reached agreement late Friday, settling on a more simplified structure than had been proposed, said this person, granted anonymity because he was not authorized to talk for the group...

Now, Henry M. Paulson Jr., the Treasury secretary, is describing the proposal’s benefits as helping “at the margin.” In an interview on Thursday, before the latest agreement was made, he acknowledged that the proposed backup fund would not rescue troubled SIVs, only lead to a longer and more orderly demise.

“This is something that is not a savior,” Mr. Paulson said, noting that he expected the fund to begin operating by the end of the year. “Anything at the margin that will speed up liquidity is worth trying.”

So the whole point, as we already knew, is to put off the inevitable in the hope that the market for some of these assets recovers and that banks can avoid bringing them back on balance sheet. On the back of yesterday's market action it seems investors are still very skeptical about the benefits of the fund and rightfully so. Given that the fund may not get up and running until the end of December it may be too late for some SIV's that don't have the benefit of Citigroup standing behind them.