SIV(a), The Destroyer of Worlds:
Are Structured Investment Vehicles (SIVs) The Next Monster Dominos in the Subprime Liquidity Crunch?

By Barry Bates
President/CEO
InsideValuation, Inc.
email: bbates@insidevaluation.com

In the Hindu trinity of Brahma, Vishnu and Śiva preside over creation, preservation and destruction respectively; in the last days of this Kali Yuga (final age), Śiva (pronounced SHEE-vah) has to do the dirty work: the destruction and absorption of our universe.   His consort, Kali, after whom the end times are named, is a  helpmate in this task; she resides at the cremation ground, chopping up demons and wearing her signature garland of skulls and girdle of forearms.    Before they get down to business, though, both of these devas are benign protectors of their devotees; Kali defends her flock with her bloody sword and bestows boons, Śiva sits in deep meditation as an inspiration to ascetic Shaivites around the world.

I wonder, though, if Śiva doesn’t have a partial namesake on Wall Street:  the Structured Investment Vehicles, known commonly as SIVs?  Like the aftermath of the subprime mortgage meltdown, Śiva rides into town on a Brahma bull, not on a bear (as on The Street, bears have a bad name in India).   After the mortgage boom,  the financial markets seem to be abuzz with gloom, doom and rumor as to what would happen if SIVs “unwound”.

Structured investment vehicles issue short-term and medium-term commercial notes, using the revenue to buy longer-term assets like bank debt and residential mortgages that produce higher yields.   But this summer SIV short-term funding dried up as investors backed away from the possibility of a steep drop in the market value of some mortgage assets.   Still don’t get it?   Makes my head hurt, too.    Market contrarian Bill Fleckenstein as a better SIVs for Dummies explanation:

“…for those folks who can't quite wrap their arms around what an SIV, SPIV, or conduit is, those names all stand for pretty much the same thing -- special-purpose entities that reside off balance sheet. Think of them as virtual S&Ls, which can be quite sizable. ... And, because they're off-balance-sheet, they operate with little regulation.”

The amount of capital invested in these huge buckets of commercial debt is about $400 billion (that’s “billion” with a “b”).   As one Wall Street banker told me at the recent MBA convention in Boston, “Hey, if it was only $50 billion, we could just wipe our hands and be done with it.   But if $400 billion in ABCP [asset backed commercial] and other paper remains illiquid for much longer, we could be looking at an economic disaster of global proportions.”

This guy is not the only one on the Street with little beads of sweat forming on his brow.  As I toured New York’s midtown and downtown last week (in my new incarnation as a sleazoid vendor peddling streamlined commercial real estate valuations), the same words were on everyone’s lips:  “I don’t even want to speculate about what would happen if the SIVs unwind.”

In order to forestall a Financial Judgment Day, Citigroup, which owns about $80B of SIV instruments, will benefit—at least temporarily-- from a cash infusion by a coalition of commercial and investment banks to maintain liquidity and avoid the forced asset selloff at distressed prices that has begun among some European SIV managers.

Although banks are still lending money to small- and medium-sized businesses and financing huge M&A transactions, there are clouds on the horizon and there’s no doubt that the collapse of subprime mortgage liquidity is contributing to SIV stress and strain.  Consider the following events:

• Since the end of 2006, over 150 subprime mortgage lenders have either stopped lending or have closed their doors altogether (according to www.lender-implode.com);
• The sharp increase in foreclosures has deeply depressed home prices; although this was supposed to be just a bump on the road, there are 3 more years of interest-only and rate resets ahead at the same time that first-time homebuyers are being forced out of the market with the near disappearance of 95%+ financing and higher FICO score minimums;
• The nation’s largest home lender, Countrywide, took down $11.5B in pre-committed credit line funds recently; almost immediately thereafter, Bank of America helped CW out with another $3B stock acquisition, on which BA has already probably lost about $1.2B as CW’s stock continues to subside;
• In the largest single write-down in market history, Merrill Lynch took an $8.4B hit to the bottom line last week as a direct result of its position as a market leader in production of collateralized debt obligations (CDOs), complex conversions of debt to bonds in which subprime mortgages comprised a huge portion.

The Fed may be moving to step in with cash as well, but the worry is that it may be too little, too late.  “The threat that Citigroup would have to step in to prop up the SIVs, pissibly requiring the use of its balance sheet, has since mid-September prompted officials at the Treasury Department  to help organize a $100 billion super-fund to buy such assets to reduce the impact of fire sales. (Wall Street Journal, ”   A show of hands: who remembers the RTC?   If there’s $400B out there, how much will $100B help?   There’s a certain irony that large bank holding companies may have to use their own balance sheets to write down the assets:  the attraction of mortgage CDOs and SIVs is that they’re off-balance sheet investments underwritten mostly by offshore Cayman Islands entities.   Hey, I’m just an English major (did you want fries with that?), but huge investments that don’t show up on balance sheets sound like an invitation to an international frenzy of pillaging and burning.   You’d think that any self-respecting gang of barbarians would at least be smart enough to pillage before they burn!  The mortgage barbarians have always had a better tool in the “neutron mortgage” (it destroys the borrower, but leaves the property intact).

If SIV assets have to be sold off into a weak credit market, it might force the banks to further downgrade the value of other short term assets, spooking investors even more.  As a market contrarian at www.dealbreaker.com noted,

“One solution would be for the banks to take the SIVs onto their books, essentially bailing them out.  They want to avoid this at all costs after already having suffered major losses in the credit markets.  It has also created a kind of prisoners dilemma, where some banks are hesitant to take the SIVs on book for fear other banks might dump the assets into the market.

The Treasury Department organized a way out of this dilemma: cooperation. Secretary Hank Paulson and Robert Steel put together a series of meetings of the big players to help them organize a cooperation solution.  And the result is a Super SIV, another off-balance sheet vehicle funded by the banks that will buy up the assets of the troubled SIVs.

The move is being criticized as a bailout of Citigroup, in particular, and of the banks which started the SIVs in general.   People are making comparisons to Long-Term Capital.  The lead critic seems to be John Malkin, a principal at Caxton Associates who has said the plan “stinks.”
Interestingly, neither Bank of America nor JPMorgan Chase have SIVs under their aegis.  So what’s in it for them?  Allegedly, they are in it for the fees. Citi, BofA and JP Morgan all stand to make money from fees for starting the Super SIV. But we’re also hearing from anonymous sources that both JP Morgan Chase and Bank of America were worried about broader credit market fall-out from a SIV-asset dump, and this helped make them eager participants in the Super SIV.

Credit market innovator Charles Ponzi could not be reached for comment.”
This oblique reference to Ponzi schemes reminds me of another observation by Scott Patterson, the Journal’s  Ahead of The Tape columnist; last week, he noted that, of course, the cash infusions may result in a blow over of the whole credit crisis and a mild recession at worst.   Tellingly, he concludes with, “But that’s not what I expect to be writing in October of 2008.”

If you’re interested in getting a better perspective on this historically significant “disruption” in the credit markets, the Merrill Lynch story is worth reading.   Two recent cover articles in the Journal (WSJ, 10/25/07) detail the adventures of Christopher Ricciardi, the “grandfather of CDOs”, who parlayed Merrill’s nonexistent 2003 CDO position to the biggest in the industry by late 2006.   At the latter point, he flew the coop (and his $8.5M annual salary) to a smaller Merrill vendor while still touting the fabulous yields obtainable in CDO investment in the face of an already apparent residential and subprime downturn.   The tandem article details the inside and outside pressure forming against Stan O’Neal, Merrill’s CEO, as a result of the monster write-down.  More interesting than the story of the individuals involved is the evolution of the investment vehicles themselves, which development reminds us of the result of too many dollars chase too few opportunities.   In my 35-year checkered history in the mortgage business, I’ve noticed that when money wants to get out the door, nothing will stop it and plenty of folk will pick up shovels to widen the breach in the dike.   It’s hard not to question Fed monetary policy over the past several years;  keeping rates low stimulates investment, but who was thinking about the side effects of surplus equity?  

A quotation of Adam Smith (also found at www.dealbreaker.com) seems to ring hauntingly of a perennial if somewhat cynical truth:  "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices."    Optimists may have a lot of fun…but historically, the pessimists are right.

I guess the scariest part of the SIV rumblings is the personal worry I saw in the faces of the very highly placed directors with whom I rendezvoused on the Street the week before last.    As if they were moths, they seemed sorry they’d flown so close to the candle, but were resigned to their fate, whatever it may be.   Fortunately, most of them are smart enough to lead fairly balanced lives; I don’t see them leaping from office windows even under the worst scenario.    Besides, we’ve apparently learned one thing from the crash of 1929:  Wall Street office buildings no longer have windows that can be opened.