Twenty years ago, structured investment vehicles (SIVs) did not exist. During the two decades since their inception, SIVs grew to more than $400 billion in assets and represented about five percent of the U.S. corporate debt market. By the end of 2008, SIV assets had become virtually extinct. There are currently no remaining SIV assets that are not in bankruptcy or rating agency enforcement. What happened?
SIVs are offshore investment companies that manage banking assets that are not displayed on a bank's balance sheet. A bank- or hedge-fund-sponsored SIV typically invests in complex asset-backed credit market instruments. In theory, the investments are high quality. In practice, they can be illiquid and hard to value. The SIV sponsor earns management fees that are based on the difference between what the assets earn and the cost of financing the assets. In essence, SIVs are unregulated companies that engage in the banking business. Without deposit insurance, SIVs became subject to the rapid loss of funding that is generally known as a run on the bank.
In the last year, the SIV business collapsed. The remaining SIV assets are either in bankruptcy or facing rating agency enforcement. This article aims to explain this monumental change. We discuss the implications for future financial markets and suggest the lessons to be learned from this episode.
The First SIV
A typical commercial bank in the late 1980s had just survived the savings and loan (S&L) crisis and had just commenced dealing with its defaulted emerging market exposures. It needed a new source of revenue and focused on "spread banking," where it borrowed in the deposit and high-quality corporate debt markets at the London Interbank Offered Rate (Libor) and lent funds to corporate customers incorporating a five-percent to six-percent profit margin. Corporate customers used these funds to finance inventory, accounts receivable and other working capital needs. Due to regulatory constraints on branch locations, the bulk of a bank's customer base originated from one state or region, which left banks vulnerable to downturns in the regional business cycle.
In the late 1980s, Citibank was different from most other U.S. banks, because Citibank had worked with its regulators and diversified internationally. Instead of operating under the regulatory constraint of keeping all of its branches in one U.S. state, Citibank had established important branches and retail franchises worldwide. Other U.S. banks with international operations were primarily facilitating U.S. clients and did not have extensive domestic business in countries outside of the United States. As a result, the risk profile of Citibank's assets was more diversified than that of a typical U.S. bank, and Citibank operated with a lower capital ratio than most other U.S. banks. Competitors such as the California-based Bank of America and New England-based Fleet Bank were regional banks and had relatively higher capital ratios.
Unfortunately for Citibank, the Federal Reserve and other U.S. banking regulators were on the verge of implementing the recommendations of the Bank for International Settlements (the Basel Accord). These would require all U.S. banks...
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