Demystifying a Credit Crisis Bogeyman

By Rachel Barnard, Ph.D. | 11-30-07 | 02:40 PM

Among the various acronyms in the financial services world, the structured investment vehicle, or SIV, now has an evil ring to it because of its association with the credit crisis. And though SIVs do pose some real risks, we think investors should understand what those are (and aren't) and how to evaluate all the media hype surrounding them. In this article, we will explain SIVs in plain English. We will talk about how SIVs have affected the markets and what effects they might have in the future. And then we will discuss two stock picks for investors who want to take advantage of all the negative publicity around SIVs. (Click here to see all the articles in our credit crisis series.)

SIVs Explained
The term "structured investment vehicle" is a rather generic term for a fund that borrows money to invest in a portfolio of securities. The SIV borrows money from investors for a short time (borrowing short) and pays a fairly standard short-term borrowing rate (close to LIBOR, the rate at which banks lend to each other). It then invests that money in securities that pay higher interest rates. Usually the SIV makes a spread of 0.25% between its cost of borrowing and what it earns on its investments. With a big enough fund--most are well more than $1 billion--that small spread can translate into a big chunk of change.

Most of the time, this structure is pretty innocuous. SIVs have been around since the late 1980s and have historically been considered safe investments. But there are a few places where SIVs can run into trouble. The funds take on both credit risk and liquidity risk. Credit risk is the risk that the securities the fund holds drop in value. The securities are the collateral for the SIV's debt. So if the securities drop in value, the SIV might not be able to pay its creditors back. Any hint that they might not get their money back is enough to make the SIV's lenders run for the hills. And that could lead to liquidity problems. Liquidity is the ability to sell your investments to willing buyers at a fair price. Once the whiff of credit problems gets about, the willing buyers could head for the hills as well, forcing you to sell your securities for much less than they are worth and leading to a permanent capital loss.

Here is a simple example of the same principle. Say your aunt Edna leaves you a piece of property. The property is valued at $1 million. You need some money to live on, but you don't want to sell the property because you think its value will increase very rapidly. Your bank might agree to lend you some spending money with the property as collateral. This might be a great deal for you if you can borrow at a 6% rate and believe that your money will increase at 15% annually if you keep it invested in the property. Your banker might agree too. But he might not agree if the value of your property drops. Then the bank might be scared that you won't be able to pay the loan back (credit risk). Therefore, it might refuse to lend you any more money. That would mean you'd have to sell your property in order to raise the money you need for daily expenses. If the value of your property has just dropped dramatically, you probably don't want to sell at a low point, but you might be forced to (liquidity risk).

What Went Wrong with SIVs
This is exactly the scenario that has played out with SIVs in recent months. Some SIVs hold subprime securities in their investment portfolios. Although the percentages are not large and there have not been any losses yet, the hint of subprime exposure was enough to scare off the commercial paper buyers, the investors who normally lend the SIVs money. The threat of credit problems led to a liquidity crisis, and the SIVs have found it difficult or impossible to keep operating without constant sources of funding. Some had to sell assets at a loss

Many SIVs are backed by banks that agree to step in and cover a certain portion of any potential losses. HSBC (HBC) and Citigroup (C) are among the top sponsors of SIVs. However, they are not required to put these investments on their balance sheets. They are contingent liabilities, which the bank would not normally be liable for except in unusual circumstances. If those circumstances arise, however, and the bank becomes liable for paying back investors who lent money to the SIV, then the liabilities must be on the bank's balance sheet. This week, HSBC became the first bank to do this.

Why Does This Matter?
There are two categories of companies that are exposed to SIV problems: the banks that back the SIVs and any companies that lend to them.

The banks could be affected in two ways. First, they may be on the hook for making up any losses that the SIVs take from selling their assets at fire-sale prices. And second, their growth could be constrained if the SIVs come onto the balance sheet. Putting SIV assets and liabilities on the balance sheet affects the bank's capital ratios. Banks are required to hold a certain level of equity capital to back up their borrowings. Adding a host of assets that are valued at fire-sale prices, and the corresponding liabilities, would mean that a bank would have weaker capital ratios. If these weaken too much, regulators would come in and force the bank to sell assets. To prevent this, a bank would have to spend its money adding capital to its balance sheet rather than growing its business.

The other companies that may be affected are the money managers with money market funds. Money markets are major buyers of short-term debt issued by SIVs. If the SIVs can't pay their debts, the companies who offer the money funds would most likely eat the losses rather than "breaking the buck," a term for giving money fund investors anything less than 100% of their principal investment back.

Stock Values amid the Fear
When we understand the actual risks that SIVs pose, there is no reason to be afraid of the dark. One of our favorite stock picks that has been mentioned in connection with SIVs is Federated Investors (FII). Federated is one of the world's largest and most skillful managers of money market funds. So far, it has sailed through the SIV storm unscathed, and none of its money funds have taken losses. Federated does very meticulous credit work on the investments it puts in its money funds, unlike some of its competitors. We expect it to emerge a stronger firm as many of its competitors lose clients to Federated's safer funds. We also think Federated might have an opportunity to acquire other money fund assets as companies burned by SIVs and subprime exposure exit the business. Federated is a favorite recommendation of ours for conservative investors.

For investors seeking more risk with more upside, we recommend a look at Citigroup. Our recent article on the firm discusses the SIV risk, but we believe that all the bad news is priced into the stock and then some. Even if Citi has to put its SIVs on the balance sheet, the bank would continue to be well-capitalized. Far from being a crippling event, backing up its SIVs would be more of a minor inconvenience for Citi.

The SIV scare may turn out to be more of a tempest in a teapot. But even if its effects spread more widely, the price is right for some firms with SIV exposure, and we wouldn't throw out the baby with the bathwater.