Role of structured investment vehicles in times of crisis

Policymakers and investors have been obsessed in recent years with the potential of a hedge fund collapse to cause financial panic. But it seems that one of the biggest threats to stability comes from the age-old risk of short-term borrowing to finance investments in long-term illiquid products.

In a corner of the market that few people knew existed, regulators are scrambling to understand what’s going on in structured investment vehicles (SIVs), a breed of often huge programs, mostly run by banks, designed to take advantage of the difference between short-term borrowing rates and longer-term returns from structured product investments.

These have mushroomed in recent years and control assets worth hundreds of billions of dollars. Depending on whether they are fully rated by credit rating agencies and how well they have to comply with certain rules, they are called SIV, SIV-lites or conduits.

They are generally quite opaque, invest in complex securities and often do not need to be displayed on a bank’s balance sheet.

They appear to have played a key role in last week’s liquidity crunch.

“We are in the midst of a mini-crisis in the commercial paper market, at least half of which is linked to SIV conduits,” said Robert McAdie, global head of credit strategy at Barclays.

These programs typically invest in credit market instruments, such as bonds backed by US subprime mortgages and secured debt instruments. These assets tend to be the highly rated and supposedly safe versions of those debts, but in the recent fear-provoking turmoil, they have shown how illiquid and difficult to value they can be.

The benefit to those who run such programs comes from the fact that the assets earn fairly high returns, while the conduits and SIVs finance their purchases with short-term loans in which interest and principal payments are backed by financial assets deemed to be stable. cash flow. Collectively, this so-called “asset-backed commercial paper” – or ABCP – lasts anywhere from a few days to a few months before it needs to be repaid.

The problem could be highlighted when billions of dollars in ABCP matures today and Wednesday, with great uncertainty as to whether it can be refinanced.

Everything about this market depends on whether investors in the ABCP market maintain their confidence in the programs and assets they hold. With the current rush to exit many structured credit markets, that faith has basically evaporated. No investor knows exactly what assets SIVs and conduits hold, or how damaged those holdings could be.

While many non-SIV funds – such as those managed by BNP, Axa and others that have experienced problems recently – have been able to prevent investors from withdrawing their money, SIVs and conduits that see their funding expire on a regular basis do not. have no such luxury.

In the event of a market turmoil, SIVs and conduits are backed by liquidity facilities from well-rated traditional banks. This means that banks must step in to provide funding if the SIV cannot raise commercial paper in the normal way, unless the SIV’s assets suffer significant downgrades in their rating. Typically, the line of credit provided by the sponsoring bank and a group of other members of a syndicate should cover 100 percent of the outstanding commercial paper.

These lines of funding have rarely been drawn in recent years, as liquidity has been plentiful in the ABCP market as it has almost everywhere else in the financial world. As recently as mid-June, the European commercial paper market was posting record emission levels.

However, what sparked the unrest last week – and the dramatic intervention by central banks – was a chain of pernicious events. When it became evident this summer that the US subprime mortgage problems were worsening and infecting a wider range of structured products, some investors in the ABCP market began to worry whether SIVs were also sitting on losses.

The rush to sell structured products by hedge funds facing redemptions and other investors meant that market values ​​that could be determined were severely depreciated. As a result, in mid-July, some investors decided to stop buying ABCP paper from SIVs suspected of subprime exposure.

The German bank IKB was one of the first victims. Like many local peers, he had a conduit – called Rhineland Funding – that had grown rapidly and held nearly € 20 billion ($ 27.3 billion, £ 13.5 billion) of paper. commercial in circulation in the markets in July. In mid-July, ABCP investors refused to renew some of these notes.

The Rhineland asked IKB to provide a line of credit, as required by SIV rules. But it appears the German bank did not have enough liquidity to meet this demand and was unable to liquidate enough assets to close the gap. It threatened to trigger the collapse of IKB, until KFW, Germany’s state-owned bank, stepped in and offered a € 8 billion credit facility.

German officials hoped this action would stop the growing panic in the area. But it may have had the opposite effect: investors started shying away from almost all of the commercial paper issued by SIVs.

“It’s an environment where there has been a great loss of confidence and no one distinguishes between apples and oranges,” McAdie notes.

By the beginning of August, the problems in the ABCP market had become so severe that some European banks were preparing for additional calls for lines of credit to SIVs. But banks are also struggling with a backlog of unsold leveraged loans, putting additional pressure on their balance sheets.

So, at the start of the month, some European banks – and some American institutions as well – quietly started trying to raise new lines of credit on their own. This, however, raised additional alarms, as rumors spread about the potential losses of SIVs – in addition to problems in other corners of the financial world.

As a result, in the middle of last week, some banks started closing lines of credit to a long list of institutions. “Commercial paper is now funded on a daily basis. Banks won’t be rolling paper for three months, ”says Dominic Konstam, Head of Interest Rate Strategy at Credit Suisse.

And while it appears that European financial institutions were particularly victims of this credit crunch, the problems – perhaps ironically – were extreme in US markets, as SIVs typically raise much of their funding in dollars. . A 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 an end of career experience.

Policymakers are hopeful that some of that panic will dissipate this week after massive emergency liquidity injections by the ECB and the US Federal Reserve. And indeed, at the end of last week, lending rates were stabilizing. There were signs that vulture funds were circling around, ready to pick up ABCP paper at bargain prices.

“What some people are hoping is that the bottom fishermen will emerge and help the market self-correct,” says a large ABCP issuer.

However, no one close to this industry expects to see a quick fix soon. Commercial paper interest rates have not yet come down, regardless of central bank actions. On Friday in New York, they closed at their highest level in six years.

There is deep uncertainty about what central banks will do next, which makes ABCP players even more reluctant to resume issuing and trading. “No one is going to handle the commercial paper if they think the Fed might be about to cut rates or do something completely unexpected overnight,” one said.

However, the third and most pernicious problem is that it becomes clear that central banks cannot solve the bigger problem – a lack of clarity on valuations in structured credit markets and the almost complete loss of confidence that infects even the largest and most diverse of ducts. -type programs.

Additional reporting by Michael Mackenzie, Richard Milne and Stacy Marie Ishmael