Shadow banking and leaking SIVs

Henry Tabe

04 July 2011

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The decimation of shadow banking that began in summer 2007 set in motion the crisis that has since engulfed the global economy. A much-maligned culprit in this process has been the shadow-banking sector. Despite significant shrinkage due to the crisis, shadow banking still represented, in 2010, more than half of outstanding liabilities in the global financial system (Pozsar et al. 2010). Given the crucial role played by securitisation within shadow banking, it is perhaps unsurprising that both the IMF (2009) and the Financial Stability Board (2009) believe that a less fitful and more confident return of securitisation is the key to a sustainable global recovery.

The structured investment vehicle (SIV) was the shadow bank par excellence. It played the important intermediation role of channelling savings in money market funds, petrodollars, and global trade surpluses to financial institutions and originators of securitised assets across the globe (Tabe 2010). A successful re-launch of securitisation will require SIV-like real money investors to assume the risks erstwhile held by this market segment.

Few were familiar with the $400 billion, 20-year old SIV sector in summer 2007 when it gained notoriety for sudden defaults and multi-notch downgrades by credit rating agencies.

SIVs were hybrid companies that combined features of traditional banking, hedge funds, and securitisation. They borrowed short mainly from money-market funds, and lent long to banks and securitisation issuers, employing leverage to amplify profitability. They issued long-dated hybrid capital comparable to bank subordinated debt. Like securitisation transactions, they were bankruptcy-remote and operated under tight limits.

At the pinnacle of their success, SIVs were the Rolls-Royce of modern finance – efficient machines equipped with smart, risk-averse managers. Most reputable institutions established or considered sponsoring SIVs. Rating agencies featured long pipelines and SIV analysts were at a premium.

The run on SIV-lites

SIV-lites were abridged versions of SIVs with predominantly mortgage-backed assets funded with shorter-dated liabilities.
In mid-2007, two hedge funds sponsored by Bear Stearns became distressed. The bank announced precipitous asset-value declines and complained that prices did not reflect fundamental value. Some of the funds’ assets were similar to those of SIV-lites and their lenders included institutional sponsors of SIV-lites. The stage was therefore set for a run on the sector. This occurred in summer 2007 as money-market fund investors exited in droves (Tabe 2010).

Too little, too late

The US Treasury, keen to avoid money-market fund defaults, tried to establish the ill-fated Master Liquidity Enhancement Conduit . The conduit would have purchased SIV assets and injected liquidity into the sector. It was therefore intended as a belated lender of last resort to SIVs.

The plan proceeded too slowly relative to the leakage of liquidity through SIVs, and was too little, too late. The implementation delays reflected, in part, inadequate analytical resources and poor understanding of SIVs. Such resource constraints seemed a common theme among governmental agencies and regulators, notably the Federal Reserve, the Bank of England, the Financial Services Authority, and even the Bank for International Settlements. They all began their SIV education when the requirement seemed decisive action as implemented for banks.

Regulators and central bankers were joined by rating agencies in misjudging the speed and ferocity of the crisis as it affected SIVs. The rating agencies even appeared in competition for meteorological metaphors to calm investors’ nerves. In July 2007, Moody’s reported that the sector was a “calm oasis”. Standard & Poor’s followed a month later with a claim that its SIV ratings were “weathering current market disruptions”. Vehicle implosions and multi-notch rating downgrades began only a couple of days after the Standard & Poor’s report.

Liquidations, lawsuits, and bailouts

Forced liquidations and lawsuits followed vehicle collapses. Entire portfolios were offloaded in fire sales that generated losses of 60%-95% for senior investors. Courts in New York and London were called on to interpret seemingly convoluted and conflicting clauses in legal documentation, exacerbating the pain for investors who had hitherto believed their top-rated securities to be near-bulletproof. Some cases filed in 2007 and 2008 were not concluded until mid-2010, while a case involving the largest vehicle, Sigma Finance, became one of the first to be heard by the newly constituted UK Supreme Court. Major sponsors bailed out their vehicles’ senior investors to prevent reputational damage, leaving vehicles that did not enjoy strong sponsorship to default on their debt.

Complexity and opacity masked deeper causes

Complexity and opacity were the first explanations proposed by some market participants for the sector’s troubles. Indeed, SIVs were among the most complex of companies as suggested by their membership of the infamous alphabet soup club of structured credit products. The sector was also widely perceived as opaque in its operations and lacking in disclosure to investors and rating agencies.

But when we consider the difficulties faced by other less complex and supposedly more transparent market segments such as money-market funds, investment banks monolines, commercial banks, and sovereign countries, they suggest that the SIV’s demise has deeper causes.

Macroeconomic and systemic causes

SIVs were a product of the liquidity bubble that began engulfing the credit markets some 20 years before their demise. This period happens to coincide with the sector's lifespan. Trade surpluses from savings economies and petrodollars from oil-producing nations led to a significant reduction in the global cost of credit. Ordinarily risk-averse investors in search of high-yielding products settled on SIV paper as an attractive alternative to US Treasuries.

Banks searching for new ways of generating incremental revenue set their sights on SIV management fees. Subordinated debt investors saw SIV capital notes as a means of earning steady returns in a market-neutral environment supported by highly rated and well diversified portfolios. The agencies earned fees estimated at a staggering $175 million to $200 million for rating and surveillance activities during the sector’s lifetime. The SIV therefore seemed a resilient winning model for all. This view was enhanced by the sector’s effortless weathering of seemingly severe historic market disruptions.

Bubble fever

SIV actors showed some of the classic symptoms of bubble fever – complacency and hubris. While a run on the sector and simultaneous drops in asset values were possibilities, invoking such a spectre invited refrains from seasoned professionals of the availability of funding alternatives and the impossibility of a protracted debt market freeze. Practitioners further relied on supposedly liquid assets to generate funding in the event of a crisis. These responses seem characteristic of a bubble mentality. Key actors appeared too engrossed in the revenue imperative to perceive the burgeoning credit and liquidity bubbles.

Risk management and regulatory lessons

Risk management requires identification, measurement, aggregation, and effective management of risks. It should help businesses allocate sufficient capital for survival and growth. The SIV’s extinction highlights risk management failures by the vehicles, their sponsors, rating agencies, policymakers, and regulators.

Financial regulators permitted bank, insurance company, pension, and hedge-fund sponsors to establish SIV “mini-banks” without ensuring that they maintain sufficient capital or back-stop liquidity in the event of a run. Policymakers also seemed unaware of the knock-on effects of the SIV’s demise on the securitisation and global credit markets. The Financial Security Authority’s call for regulators to incorporate sectoral analytical capabilities in their micro-prudential policies should help close the knowledge gap and ensure that timely solutions can be implemented to avert collapses that engender significantly more stress on the financial system (FSA 2009).

Lessons learned include the tightening of regulation governing the sponsorship of off-balance-sheet structures and the sizing of their capital and liquidity needs. These require that regulators adopt a more proactive, dampening role in the wild swings from exuberance to despair that are so characteristic of the financial markets. Discussions around contingent capital and similar products suggest regulators have embraced that dampening role and moved away from the prevailing pre-crisis philosophy of minimal regulation. 

Lessons learned also include closer supervision of shadow banks, more skin-in-the-game for their sponsors, in-house retention of risk-analytics capabilities by investors, and less reliance on credit-rating agencies. The agencies themselves are more tightly supervised in order to reduce ratings shopping by issuers and inherent conflicts of interest in the business model (CESR 2009). Tighter regulation will also help to ensure that the agencies improve the monitoring of analyst performance, qualifications, and experience (Dodd-Frank 2010).

These measures should help restore confidence in rating agencies and the global financial system, an outcome more urgently required given on-going turmoil in the sovereign debt market.

References

CESR (2009), Regulation (EC) No 1060/2009 of the European Parliament and of the Council, 16 September.

FSA (2009), The Turner Review: A regulatory response to the global banking crisis, March, p. 89.

FSB (2009), Improving Financial Regulation, Report of the Financial Stability Board of G20 Leaders, September, p.11-12.

IMF (2009), Global Financial Stability Report, October, pp. 32-33,80-115.

Pozsar, Zoltan, Tobias Adrian, Adam Ashcraft, Hayley Boesky (2010), “Shadow Banking”, Report 458, Federal Reserve Bank of New York, July.

Tabe, Henry (2010), The Unravelling of Structured Investment Vehicles: How Liquidity Leaked Through SIVs, Thoth Capital Publishers, p.105-110 & & p 10-11.

The Dodd-Frank Wall Street Reform and Consumer Act (2010), US Public Law no. 111-203.

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Topics:  Global crisis International finance

Tags:  shadow banking, structured investment vehicles

Founding Partner, Sequoia Investment Management Company Ltd.

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