In parts of markets where not many people knew about their existence, regulators are trying to understand what is happening in these so called SIVs (Structured Investment Vehicles). A ‘bunch’ of investment assets attempting to make a profit from credit spreads between short term debt and long term structured finance products, for instance ABS (Asset backed Securities). ABS are financial securities backed by loans, leases or receivables against certain assets other than mortgage backed securities and real estate. From investors’ point of view, ABS are an substitute for investments in corporate debt.
Funding for SIVs comes from the issuance of commercial paper that is continuously renewed or rolled over; the proceeds are then invested in longer maturity assets that have less liquidity but pay higher yields. The SIV earns profits on the spread between incoming cash flows (principal and interest payments on ABS) and the high-rated commercial paper that it issues. SIVs often employ great amounts of leverage to generate returns.
The spread between benchmark securities and other debt securities
that are comparable in all respects except for credit quality (e.g., the
difference between yields on U.S. treasuries and those on single
A-rated corporate bonds of a certain term to maturity).
Also known as "conduits".
Investopedia Says... SIVs are less regulated than other investment pools, and are typically held off the balance sheet by large financial institutions such as commercial banks and investment houses. They gained much attention during the housing and subprime fallout of 2007; tens of billions in the value of off-balance sheet SIVs was written down as investors fled from subprime mortgage related assets.
Many investors were caught off guard by the losses because little is publicly known about the specifics of SIVs, including such basics as what assets are held and what regulations determine their actions. SIVs essentially allow their managing financial institutions to employ leverage in a way that the parent company would be unable to due to capital requirement regulations.
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These have proliferated in recent years and control assets worth hundreds of billions of dollars. Depending on whether they are fully rated by credit rating agencies and on how strictly they have to conform to certain rules, they are known as SIVs, SIV-lites, or conduits.
They are typically quite opaque, invest in complex securities and often do not need to be displayed on a bank’s balance sheet.
It seems they have played a key role in last week’s liquidity crunch.
“We are in the middle of a mini-crisis in the commercial paper market, at least half of which is related to the SIV conduits,” says Robert McAdie, global head of credit strategy at Barclays.
These programmes typically invest in credit market instruments, such as US subprime mortgage-backed bonds and collateralised debt obligations. These assets tend to be the highly rated, supposedly safe versions of such debt, but in the recent fear-driven turmoil have shown just how illiquid and hard to value they can be.
The profit for those who run such programmes comes from the fact that the assets pay fairly high yields, while the conduits and SIVs fund their purchases with short-term borrowings in which interest and principal payments are backed by financial assets that are deemed to have stable cash flow. Collectively this so-called “asset-backed commercial paper” – or ABCP – lasts for anything between a few days and a few months before needing to be refunded.
The problem could be thrown into relief when billions of dollars of ABCP mature today and on Wednesday, with great uncertainty as to whether this can be refinanced.
Everything in this market depends on investors in the ABCP market maintaining their faith in the programmes and the assets they hold. With the current rush for the exits in many structured credit markets, this faith has been evaporating wholesale. No investors are sure exactly what assets SIVs and conduits are holding, or how damaged those holdings might be.
While many non-SIV funds – such as those run by BNP, Axa and others that have hit trouble recently – were able to stop investors pulling their cash out, SIVs and conduits who see their funding expire on a regular basis have no such luxury.
In the case of a blip in the market, SIVs and conduits are supported by liquidity facilities from highly rated, mainstream banks. This means banks must step in to provide finance if the SIV cannot raise commercial paper in the normal way, unless the SIVs’ assets suffer significant ratings downgrades. Typically, the credit line provided by the sponsoring bank and a group of others in a syndicate must cover 100 per cent of outstanding commercial paper.
These funding lines have rarely been drawn in recent years, because liquidity has been abundant in the ABCP market as almost everywhere else in the financial world. As recently as mid-June, the European commercial paper market was seeing records levels of issuance.
However, what sparked last week’s turmoil – and the dramatic intervention by central banks – was a pernicious chain of events. As it became apparent this summer that the US subprime problems were worsening and infecting a broader range of structured products, some investors in the ABCP market started to worry about whether SIVs were also sitting on losses.
The rush to sell structured products by hedge funds facing redemptions and other investors meant those market values that could be ascertained were being marked down heavily. As a result, by mid-July some investors decided to stop buying ABCP paper from SIVs suspected of subprime exposure.
The German bank IKB was an early victim. Like many local peers, it had a conduit – called Rhineland Funding – which had expanded rapidly and had almost €20bn ($27.3bn, £13.5bn) worth of outstanding commercial paper in the markets in July. In mid-July, ABCP investors refused to roll over some of these notes.
Rhineland asked IKB to provide a credit line, as the rules of SIVs require. But it appears the German bank did not have enough cash to meet this request and was unable to liquidate enough assets to plug the gap. This threatened to trigger IKB’s collapse, until KFW, the state-owned German bank, stepped in and offered an €8bn credit facility.
German officials hoped this action would stop growing panic in the sector. But it may have had the reverse effect: investors started to shun almost all commercial paper issued by SIVs.
“This is an environment where there has been a big loss in confidence and nobody is distinguishing between apples and oranges,” notes Mr McAdie.
By early August, the problems in the ABCP market had become so serious that some European banks were preparing for additional calls on credit lines to SIVs. But the banks are also grappling with a backlog of unsold leveraged loans, which is placing additional pressure on their balance sheets.
So early this month some European banks – and a few US institutions as well – quietly started trying to raise new credit lines themselves. That, however, triggered additional alarm, as rumours spread about the potential losses at SIVs – on top of problems in other corners of the financial world.
Consequently, by the middle of last week, some banks started shutting credit lines to a sweeping list of institutions. “Commercial paper is now being funded on an overnight basis. The banks will not roll paper for three months,” says Dominic Konstam, head of interest rate strategy for Credit Suisse.
And while it seems that European financial institutions were particular victims of this credit squeeze, the problems – perhaps ironically – were extreme in US markets, since SIVs typically raise a large proportion of their finance in dollars. One banker admitted last week: “The attitude is ‘Don’t show me anything east of a [New York] 212 area code’. If you lend to [those banks] it could be a career-ending experience.”
Policymakers hope that some of this panic will dissipate this week following the massive emergency injections of liquidity by the ECB and US Federal Reserve. And indeed, by the end of last week, borrowing rates were stabilising. There were signs vulture funds were circling, ready to pick up ABCP paper at bargain prices.
“What some people are hoping is that the bottom fishers will appear and help the market self-correct,” says one big ABCP issuer.
However, nobody close to this sector expects to see a quick solution soon. Commercial paper interest rates have not yet fallen, irrespective of central banks’ actions. In New York on Friday, they closed at their highest level for six years.
There is deep uncertainty about what the central banks will do next – making ABCP players even more reluctant to start issuing and trading again. “Nobody is going to handle commercial paper if they think the Fed could be about to cut rates or do something else completely unexpected overnight,” explains one.
However, the third, most pernicious problem is that it is becoming clear central banks cannot resolve the biggest problem – a lack of clarity about valuations in structured credit markets and the almost complete loss of confidence that is infecting even the biggest and most diversified of conduit-type programmes.
Sovereign wealth funds - government-controlled investment funds - are one of the hottest topics at the World Economic Forum in Davos. But are they really dangerous?
Richard Fuld, Lehman Brothers chief executive
Richard Fuld says the funds could soon control up to $20 trillion
Picture this: You are finance minister and several very large banks in your country are in trouble. An investment fund steps into the breach and provides the much-needed cash - say $10bn (£5bn) or thereabouts. It helps to avoid a financial meltdown.
So far so good. But what if this fund is controlled by a foreign government with unclear intentions? What if such a fund also wants to buy your nation's most important ports?
And what if the fund takes a large stake in a business that is a rival to its country's national champion?
Across the Western world, politicians are grumbling, and economists and business leaders are pricking their ears.
In Davos, the session on the "myths and realities of sovereign wealth funds" was oversubscribed.
There is a certain deja vu to this debate.
Two years ago the leaders of hedge funds had to defend their track record.
Last year it was the turn of private equity firms.
Now the men and one woman in charge of some of the world's largest sovereign wealth funds took to the Davos stage to defend their track record.
Saving for the future
But what are sovereign wealth funds? Well, some countries have a lot of cash, for example from oil or gas revenues. They invest some of that money for a rainy day, or for the time after the oil runs out.
Muhammad Al Jasser
Sovereign wealth funds have been found guilty before being proven innocent
Muhammad Al Jasser,
Vice governor, Saudi Monetary Agency
Some, like Saudi Arabia, use it to smooth out shortfalls in the government budget.
"We need these investment funds for future generations, we don't use them to speculate," said Aleksey Kudrin, Russia's finance minister.
The panellists in charge of such funds proclaimed that their intentions were pure; they were investing for the long-term, and had a total hands-off approach to the management of the companies they buy.
"Our fund started in 1953," said Bader Al Sa'ad, the managing director of the Kuwait Investment Authority. "Kuwait has been a Daimler shareholder since 1969...BP shareholder since 1986, we are one of the most stable shareholders of these companies."
"All the worries [about sovereign wealth funds] are not based on a real case, but on assumptions."
The $20 trillion investors
Maybe it is their size that is intimidating.
On a conservative estimate they have assets worth about $3 trillion.
Richard Fuld, chief executive of investment bank Lehman Brothers, predicted that - with other state-controlled firms taken into account, these countries would control $15-20 trillion in 5 years.
The owners are 15 governments, and five of them control 70% of the total.
'Model investors'
With the notable exception of Norway, these funds are fairly secretive.
Lawrence Summers
Former treasury secretary Larry Summers worries about hidden motives
They don't publish their investment strategy and are not publicly accountable.
But that doesn't make them bad, argued Mr Fuld.
They have money, the capital markets need this cash, and being long-term investors they can "stabilise the business cycle".
Stephen Schwarzmann, chief executive of private equity giant Blackstone, derided the notion that these funds were a threat: "It's almost amusing to see that pools of capital that we have always dealt with now have a new name, sovereign wealth funds, and are seen as an inherent threat."
He described the funds as "model investors", "smart, highly professional," simply looking for the best possible return for their money.
"When the Chinese investment fund took a 9.5% stake in our company there were questions in the press: 'why do they do this, what are their motives?'"
"Well, it's a non-voting investment, that was important for them...they said they don't want to vote."
What if?
But Larry Summers, Harvard professor and once US treasury secretary, had his doubts.
These funds had to understand that governments worried about possible hidden motives.
What if a state invested in a firm and then started making suggestions? Proposed to an "airline to fly to their country, want a bank to do business in their country, or want a rival to their country's national champion disabled"?
And what if a country's investment fund ran an active trading operation and - George Soros style, when he brought down the pound - decided to launch a large-scale speculative attack on another nation's currency?
Mr Summers called on sovereign wealth funds to be transparent about their investments and strategy, and sign a binding code of conduct.
While Norway's finance minister, Kristin Halvorsen, said she was happy to do that, her peers were more circumspect.
Muhammad Al Jasser, vice governor of Saudi Arabia's Monetary Agency, did not understand the call for regulation.
There had been "failures galore" in the world of hedge funds, but all attempts of regulations had been rejected, because they would "interfere with the smooth working of financial markets".
The behaviour of sovereign wealth funds had been without fail, and now they "seemed to have been found guilty before being proven innocent".
Kurt Bjorklund, one of the business leaders here in Davos and managing partner at private equity firm Permira, was sanguine: "there are no economic problems with [sovereign wealth funds], the debate is about political problems."
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