Today, if you read the financial media, you will often come across a bewildering series of alphabet soup associated with the infamous credit and sub-prime crisis: CDO, SIV, ABCP, LIBOR, MBS, ABS etc. Although they sound very technical and mysterious to the uninitiated, the essence of their meanings is actually very simple. Today, we will unravel yet another one of these alphabet soups: SIV. Before you continue reading this article, it would be good if you can revise your understanding of the securitisation process (see How to dump risk to consumers: securitisation) and CDO (see Collateral Debt Obligation?turning rotten meat into delicious beef steak).
Recall that back in How to dump risk to consumers: securitisation, we mentioned that
With the recent financial ?innovation? of debt securitisation, lenders can now aggregate their loans, and through dicing, slicing, splicing and divesting, repackage it into an ?investment? product… These ?investment? products are then sold to retail investors (i.e. consumers) directly and indirectly (through their retirement funds).
Now, imagine that you are a lending. After lending your money to a mortgagee borrower, your loan to the mortgagee borrower becomes an asset in your balance sheet (and a liability in the mortgagee borrower’s ‘balance sheet’). Thus a link is formed between you as a lender and the mortgagee borrower as a borrower. As we said before in Collateral Debt Obligation?turning rotten meat into delicious beef steak,
Today, through the financial ?innovation? of securitisation, the link between lenders and borrowers were broken. It has developed to the point whereby the one who is lending you the money is not the one who has to bear the loss or clean up the mess when you default on the loan.
So, how can this link be broken between the lender and the borrower? Here comes the Structured Investment Vehicle (SIV) which is a type of “conduit.” Basically, a SIV is a fund that buys those mortgage assets from the lender. By doing this, the lender can offload these mortgage assets from its balance sheet.
The next question is: where does the SIV get its money from?
As it turns out, the SIV get its money through borrowing short-term in the credit market by issuing commercial paper. Since the mortgage asset is a long term debt, the SIV basically borrows money in the short-term to finance the purchase long term mortgage assets. The difference between the short-term and long-term interest rates makes up the profit of the SIV.
The recent deterioration in the credit market is severely disrupting the SIV funds because of the high cost of obtaining short-term funding. As a result, many of the lenders have to buy back the mortgage assets from the SIV, resulting re-loading those mortgage asset into its balance sheet.
