So What Is a Structured Investment Vehicle (SIV) Anyway?

Structured Investment Vehicles, or SIVs have received much attention in the news lately as financial crisis continues to widen. Unfortunately, that attention hasn't included any kind of explanation as to what SIVs actually are. So, to help us understand the current situation better, here is a brief explanation of how a SIV operates.

Short-Term vs. Long-Term Interest Rates

First of all, we need some important background information about interest rates. Typically, short-term interest rates are lower than long-term interest rates (think of the rate on a 15-year mortgage vs a 30-year mortgage). This is because there is less risk to the lender in a short period of time than in a long period of time. A lot can happen to the borrower during those extra 15 years. That's twice as much time for the borrower to lose a job, become ill or have any number of other possible life events that make it difficult or even impossible to pay back the loan. Therefore, for two loans that are similar in every other way, the one that has the longer payback period will have the higher interest rate.

How SIVs Make Money

This difference between short-term interest rates and long-term interest rates is called the "spread." Structured Investment Vehicles are funds that are set up to profit on the spread, and here is how they do so:

• SIVs maintain a high credit rating which allow them to borrow short-term funds at near-prime rates.

• SIVs borrow money for a short period of time (often for as short as 30 days) using a tool called commercial paper

• SIVs invest the money they have borrowed in various long-term bonds, which often consist of mortgages

• SIVs collect interest at long-term rates from their investments and pay interest at short-term rates on their loans

• SIVs pay off their short-term loans by taking out new short-term loans

SIVs are able to buy large amounts of long-term bonds to hold for investment with money that has been borrowed at short-term rates. Thus, SIVs are constantly refinancing their loans with new loans while collecting more in interest than they end up paying. This can continue indefinitely, as long as there is new short-term money available to borrow when the previous loan comes due.

The Crash of the SIVs

Up until late 2007, refinancing short-term loans had not been a problem for SIVs. However, in August 2007, due largely to the fear that SIVs may be holding large amounts of subprime mortgages, banks and the commercial paper market stopped lending to SIVs at favorable rates. Since SIVs could not borrow new money, but had to pay old back loans that were now due, they were forced to sell some of their long-term investments to raise cash. Since this inability to raise money hit all SIVs at the same time, a large number of long-term investments became available for sale at the end of 2007. And just like what we are now seeing with the large number of homes becoming available for sale pushing down the price of all homes, the large number of the types of investments that SIVs held becoming available pushed their value down. This caused many SIVs to lose huge amounts of money as they sold assets at a loss in order to pay their debts.