Playing in Traffic

Handing a basket of asset backed securities to a structured investment vehicle is like telling a child to play in traffic. You knew what you were doing, and you did it anyway.

A Structured Investment Vehicle (SIV) is an independent entity that is not connected to a bank's balance sheet. This part is important, because investment banks use SIVs to keep potential liabilities out of profit calculations.

Banks set up SIVs to house baskets of assets the institution would prefer to keep off the balance sheet. In order to do this, the SIV must buy the asset pool by issuing debt.

There are two kinds of debt available to a SIV: long term or short term. Obviously, the specific combination of assets in the basket dictates the instrument best suited for the job.

Long term debt becomes a mortgage backed bond, or MBS, and can have a shelf life of several years.

A short term debt, or asset-backed paper, has a shelf life of a couple of months and needs to be re-issued and re-sold at regular intervals.

The subprime-related volatility in the debt markets, especially short-term debt, has made rolling over debt issues very difficult.

If the SIV doesn't roll over the debt, it can't afford to keep the basket.

Now, the basket itself can be a pool of Asset Backed Securities, Collateralized Debt Obligations or other rocket science projects concocted in a finance lab.

In order to give the SIV some credibility, the bank would write a put option under the basket - creating an insurance policy. If the value of the basket drops below a certain level, the bank steps in to help.

If the SIV cannot roll over its debt issue, the bank can also step in to help. This may be a result of a different put mechanism, or simply because the bank has an incentive to help.

If the bank buys up some of the unsold paper, it has a small short-term asset compared to the long-term liability of taking on the entire basket held by the SIV.

Unfortunately, the subprime crisis has complicated the scenario. Many of the complex structured assets in the SIV baskets are tied to subprime mortgages. As subprime default rates increase, the value of the structured securities they back erodes.

This means that the value of SIV baskets shrink, forcing SIVs to execute their put options.

Similarly, the subprime-related credit crunch had resulted in unfavorable debt market conditions. Even though the Fed has cut rates, investors are staying out of debt markets.

In the absence of healthy demand, SIVs are struggling to roll over their debt issues and are forcing banks to step in and help.

Essentially, the elaborate ruse of keeping these risky structured securities off the balance sheet is backfiring. Banks are not only buying up SIV paper, they are writing down SIV debt too.

Now tell me you didn't see this coming?