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Structured Investment Vehicle (SIV)
“The new yield curve arbitraging engine"
By Pradeep K Singh
CFA
--------------------------------------------------------------------------------
Arbitrage across the yield curve is not a new phenomenon for the market participants and riding the yield curve has been a primary source of income for the Banks and Financial Institutions. However the recent paradigm shift in the area of structured finance has introduced a new twist to this whole experience by leveraging the conventional technique. Structured Investment Vehicle (SIV) is one of recent entrants in this sphere of structured finance.
Structured investment vehicle or "SIV" is basically an investment company (SPV) which generates the investment returns through yield curve arbitrage by purchasing high grade (AAA, AA) medium and long term fixed income instruments and funding itself with low cost short term senior debt instruments such as Asset backed commercial paper (ABCP) and Asset backed medium term notes (ABMTN). SIV is thus a special type of CDO designed for the leveraged riding of the yield curve and generation better return for the subordinate debt (Capital Notes) and equity holders. Similar to the CDO structures, SIV funding is also classified in multiple trenches of senior and subordinate debts with residual equity funding. Typically capitalization of SIV is through a mix of equity and subordinated debt (Capital Note), which sometime is dominated by only capital notes.
SIV is one of the many instruments in the pedigree of structured finance and its origin can be traced in the Securitization ancestry. It is reminiscent to discuss the background of securitization to understand the foundation and structure of SIV.
1. Securitization in perspective
Securitization in the simple term means the creation of new securities and comes under the discipline of financial engineering. Securitization refers to the creation and issuance of new fixed income securities, whose payments of principal and interest are derived from cash flows generated by pools of assets acting as collaterals for the aforementioned securities. This structuring leads to the repackaging of cash flows into securities by adding value in terms of credibility and liquidity. Traditionally Securitization has been used a mode of financing by converting the illiquid pool of asset into more liquid marketable securities, but contemporary structuring is also motivated by higher returns, diversification, hedging objectives apart from plain vanilla funding.
Securitization history can be traced back to 1970 with the structured financing of mortgage pools in the USA . This was motivated by promotion of secondary markets in mortgages to allow liquidity for mortgage finance companies. Since the mid 1980s, better technology and more sophisticated investors have driven the asset securitization business as one of the fastest growing trend in capital markets. The growth can be visualized from the fact that outstanding securitized debt in international market is $6.6 trillion as of the second quarter of 2003 .
Indian financial market has been tardy in this area of structured initiative with its first securitization in 1991 with the Auto loan ABS issued by Citibank. Since then
Source – American Securitization Forum - Presentation before the subcommittee of the Financial Institution and Consumer Credit – United States House of representatives.
number of players and volumes have multiplied manifold. Earlier most of securitization deals have involved cars and commercial vehicles hire-purchase receivables of non-banking finance companies (NBFCs) and securitization industry in India suffered a major setback in 1997 with the crash of NBFCs. The Industry regained again in 2001 to witness the growing volumes and transaction.
Graph 1.0 – Securitization Growth in India
Source – ICRA Limited and Moody Investments Services – structured finance review.
Traditionally the growth of the securitization in the Indian market has been driven by liquidity requirements and need to manage the Asset Liability maturity mismatches similar to any other emerging economy. Though capital adequacy and aforementioned funding needs will continue to be the driver for the future growth of Indian structured finance, there will be more emphasis on better returns and leveraged arbitrage too. Hence SIV (Structured Investment Vehicle) can play an important role in achieving the multifold growth objective of the Indian Financial Institution and Banks by improving the economies of scale and scope.
2. Assortment of Structured Finance
Structured instruments come in numerous flavors ranging from the plain vanilla to complex conduits. Most widespread taxonomy is based on the underlying asset class and categories them as ABS (Asset Based Security), MBS (Mortgage Based Security), CLO (Collateralized Loan Obligations) and CBO (Collateralized Bond Obligations). The ABS is characterized by Auto loans, Credit cards, Trade Receivables as underlying pool, while MBS pool is primarily comprised of housing mortgages. CLO and CBO are jointly called CDO (Collateralized Debt Obligation) with bank loan portfolio or bond portfolio as underlying asset pool. The underlying securitized assets are also categorized based on existing and future receivables. The existing receivables are known as Asset backed, while the later known as future cash flow securitization. Also there are different types of non – asset based securitization of which securitization of future foreign exchange earning in the off shore market is very popular.
Mortgaged-backed securitization occupies greater market share in the USA , the UK and other parts of Europe , whereas in Japan and South East Asia securitization of auto loans occupies better market share. Recently mortgaged-backed securitization is also gaining popularity in Japan and Singapore . In Latin American countries securities credit cards and export receivables in the international market.
Structured finance continued to explore new frontiers of risk and return by engineering new instruments and structures. Collateralized Investment Obligation (CIO) is one of them, where bank securitize the equity investment and finally break down the cash flow of the regular dividends and growth.
Synthetic CDOs have opened new dimension to securitization by just transferring the inherent risk underlying the asset instead of transferring the cash flow from the underlying assert. Synthetic CDO at the one hand improves the risk capital return with credit default premium and on the other hand reduce the risk with diversification. These dual effects help the investors to plan a positive parallel shift in Marcowitz efficient frontier. Structured Investment Vehicle can be defined a special type of CDO with high grade debt securities in underlying pool. SIV can even have long term senior ABS and MBS securities as underlying pool for the structuring and thereby initiating the second layer of structures.
3. Structuring of Structured Investment Vehicle (SIV)
Structured Investment Vehicles (SIVs) are complex companies with similar but not identical to other Special Purpose Vehicles (SPVs) for the operational finance. SIVs demands huge investments in staffing (with analytical, hedging and cash flow modeling capabilities), technology and operational logistics. Therefore traditional banks are better positioned to operate SIVs and thereby improving the existing economies of their manpower and operational infrastructure.
SIVs act as leveraged financing vehicle to earn the spread multiple between it's long term assets i.e. Investment grade structured notes (ABS, MBS CDOs etc) or subordinated bank debt and it's short term liabilities i.e asset based commercial paper (ABCP) and asset based medium term notes (ABMTN). The vehicle targets only leveraged riding of the yield curve and try to avoid any other type of risk generated from it's asset liability structure. It tends to operate in market neutral environment and actively hedge any interest rate and foreign currency risk.
SIVs are equipped with strong structural mechanism designed to reduce risk such as defeasance event, enforcement event and insolvency event apart from regular monitoring and hedging of the interest rate and liquidity risk. Further the underlying asset of an SIV is of much higher quality than traditional ABS or MBS. Hence SIVs offer a very attractive alternative not only to traditional multi-seller ABCP conduits but it's Capital notes and MTNs offer attractive alternatives to traditional ABS & CDOs as well.
The first SIV was established in 1988 and since then not many programs has been established till date. However there is surge in demand for SIV with rising interest rate scenario in order to improve the overall returns. Similar to other traditional asset based conduits, SIV structure is also comprised of sponsor, Investment Manager, Capital note providers, Investors, liquidity provider etc. However in case of SIV, there has been increasing role of the hedge counterparties and hence most of the SIVs have direct or indirect involvement of the prominent hedge funds to manage it's market neutral environment.
SIV Sponsor is usually a investment company or bank as it is easier to reap the economies of the existing infrastructure and resources. The sponsor in the simple form can act as just sponsor and investor in the SIV for better leveraged return or may take other role such as investment manager for the investment management, treasurer for the liquidity management and risk manager for the risk mitigation of structured vehicle. Some of many roles performed by sponsor includes even operations manager, legal counsel and at time liquidity and capital provider.
In some cases these various roles are being outsourced for the specialized care and corporate governance purpose. Similar to most of the structured vehicle custodians are appointed for the management of operations and custody of the SIV assets. Some of the SIV's have outsourced the hedging activities to the specialized hedge fund and concentrate only on the investment and liquidity aspects of the SIV.
The major stakeholders in the SIVs are it's investors and capital providers and various other entities such as custodians and hedge funds are only facilitators for the smooth operation of SIV. Sponsors have a stake in SIV as they provide the majority of the SIV capital in the form of equity capital or capital notes and hence they have strong incentive to ensure maximum performance. Further due to high start-up cost, the sponsor would like to ensure the better returns to recover it's investment in SIV. Please note that unlike other traditional AB conduits, SIV sponsor is only a capital provider and underlying assets are independent. There fore credit rating of SIV's are less exposed to the credit rating of the sponsors. Further unlike traditional AB conduits, there is no need for the 100% liquidity backup and only 10% liquidity facility is provided by either sponsor or more often by several third party liquidity enhancers. Hence again the role of the sponsor is limited as compared to traditional AB conduit.
4. Composition of Assets, Liabilities and Risk Capital
SIV assets are comprised of highly rated and relatively liquid securities. Liquidity of the underlying assets reduces the overall liquidity requirement of the SIV and hence there is need of only 10% liquidity support from third party enhancement. In traditional AB conduits the liquidity enhancement may be up to 100% of the underlying asset value. A typical asset breakdown of an SIV reflects subordinated bank debts, senior classes of CDOs , ABS, MBS, long term AA and A investment grade corporate papers. However most SIVs have minimal exposure to non financial corporate debt and they prefer subordinated bank debt due to their familiarity with the product and expected high recovery rates. Though SIVs can buy the assets below investment grade too, they generally have an average portfolio rating of AA and above.
On the liability side similar to any other SPV they are multiple tranches. Senior liabilities are comprised of primarily AAA rated asset- backed commercial paper (ABCP) and asset – backed medium term notes ( ABMTN) these liabilities can be issued in multiple currencies and in multiple markets such as US and European market. The currencies and markets of the aforementioned senior liabilities are kept more or less in line with the currency of the underlying assets in order to minimize overall currency exposure. The senior liability comes under low risk and low return asset class though the overall return is better compared to similar highly rated debt securities.
Figure 2.0 – Sample SIV Balance Sheet
SIV risk capital comes from subordinated debts that are capital notes and small equity supplied by the sponsor of SIV. Capital notes comes under the high risk, high return asset class and returns are linked to leveraged yield curve arbitrage profit. Capital notes share the arbitrage profits apart from the regular fixed returns in the predefined ratios. Capital notes overall returns are effected by the leverage of SIV and directly proportional to gearing ratio. Left over profit belongs to equity capital providers and in normal circumstances generates a very high return. In case of any loss on account of change in the spread or un-hedged interest rate and currency positions, it will be first deducted from the equity capital and later will be allocated to capital note providers. Some of the SIVs do not have equity capital and use the capital notes as risk capital
5. Difference from Traditional Asset Based Conduit
SIV differs from traditional MBS and ABS primarily with respect to the underlying collateral. Traditional ABCP conduits use trade receivables, mortgages and loan as their underlying collateral, while SIVs generally use highly rated relatively liquid securities as collateral. SIV management is more disciplined with daily management of all aspects of SIV whereas ABS or MBS management comprise of less daily activities with more focus on preservation of portfolio value and monthly investor reporting. SIV also has better credit ratings (AA, A) which is independent of the sponsor rating as compared to ABS and MBS (BBB, BB). Some of the primary differences are as under :
Figure 3.0 – Comparing SIV with traditional AB conduit
6. SIV Economics
SIV economics are primarily derived from levered arbitrage across the yield curve and profit is shared by the providers of the risk capital i.e. Capital notes and equity providers. SIVs use the common principle of riding the yield curve with leveraged capital and hence the return is multifold. Further SIVs are indifferent to absolute interest rate risk as they only intend to derive their return form the spread between the underlying asset (average maturity 4-5 years) and it's liabilities (average maturity of about 6 months). Sample calculation of the return on capital note for a typical SIV is as under..
Particulars
Return computation
Spread of underlying assets
MIBOR + 50
Funding Cost (ABCP, ABMTN etc)
MIBOR + 10
Hedging fee, Trustee fee, Liquidity fee etc..
10 bps
Residual Spread
MIBOR + 30
Leverage
15 times
Overall return for SIV
MIBOR + 450
Assuming 60:40 of return sharing between capital note providers and sponsor.
Return for Capital note providers
MIBOR + 270
Return for Sponsor
MIBOR + 180
In most of the SIV structures, the Capital note provider are entitled to a base coupon, which is typically 50 to 100 bps of the residual spread and rest will depend on the leverage scenario at the time of profit distribution. As discussed above the overall return (profit) of the SIV is shared between the capital note providers and sponsor as per the predefined formulae. SIV leverage defined the risk return frontier for the risk capital providers. Lower leverage will result into lower return with low risk and higher leverage will result into the high return with high risk. Further if SIV collateral is comprised of the high rated asset with lower yields the overall return can be improved by improving the leverage without affecting the overall risk parameters. Similarly if the underlying collateral is of high return and moderate rating profile the risk can be controlled by lowering the leverage. Hence the SIV economics provides many parameters to generate the desired risk return profile.
7. Hedging and Risk Management
SIV economics and leveraged arbitraging structure is based on the premises of a market neutral environment. Hence it is imperative to completely hedge all sorts of interest rate and currency risk to derive the stipulated return from the leveraged yield curve arbitrage. SIV usually adapts to micro hedging policies in which they actively hedge each and every individual position on the asset and liability side. Dynamic hedging is an integral part of the SIV structure and a dedicated team of specialized professionals undertake this function. Some of the SIVs prefer to outsource this activity to specialized hedge funds. It has become relatively easier to perform the micro hedging with the growth in specific derivative instruments such as over night index swaps (OIS), spread swaps, etc.
Credit risks are actively counter balanced with aggressive use of the credit derivatives such as credit default swaps, total return swaps, basket default swaps, credit linked notes etc. Apart from that SIV guidelines have numerous provisions regarding initial and ongoing rating requirements and steps to be taken in the event of ratings downgrade. SIV guidelines have well defined exposure to curtail counterparty risk. Operational risk is being managed with the help of defined policies and procedures for various activities which SIV undertakes. Further most of the SIVs appoints custodians who take care of operational and regulatory issues.
The liquidity risk of SIV is managed by using maximum cumulative outflow (MCO). The MCO is equal to the largest cumulative outflows that occur during any consecutive 5 days in the up-coming 1 year period. SIVs are required to have liquidity equal to at least three times the MCO. The committed liquidity of an SIV should be generally equal to at least the MCO. SIV guidelines also define that a single liquidity facility cannot provide more than 50% of the MCO. Hence as defined above SIV resort to active management of market risk, operational risk, credit risk, liquidity risk, etc. to conform to arbitrage principles.
8. Defeasance Enforcement and Insolvency events
Structured mechanisms that are designed to reduce the risk of an SIV are defeasance event, enforcement event and insolvency event. These events defined various loss scenarios and the steps to be taken under each event. This reflects the strong guidelines for the risk management under which SIV operates. The various scenarios and related events can be defined as under.
Figure 4.0 – Structured mechanism to control risk
Widening of yield spreads or flattening of the yield curve results into losses for the SIV if it is not properly hedged and the same will affect the capital adequacy of SIV. If capital adequacy goes beyond a predefined level the defeasance event is triggered. In the defeasance process the SIV becomes less levered by suspending cash flow or dividends to the capital note holders, by selling assets or by not issuing new liabilities. The defeasance triggers differ among SIVs. Recent SIVs have seen the evolution of structures so that the SIVs have more latitude in difficult times. A defeasance trigger in an SIV would occur if the SIVs ratings fell a few notches below the SIVs targeted ratings. Thus a defeasance maintains or regains a specific rating for the SIV liability. The competency and performance of the sponsor of the SIV is critical in insuring that a defeasance event does not turn into an enforcement event.
In case the defeasance process is not successful and SIV is not able to maintain it's rating, the enforcement event is triggered. The objective of the enforcement event is to limit the further deterioration and results in the sale of the portfolio. The enforcement event provides extra protection for the holders of the SIVs ABCP and ABMTN holders. The events that would automatically trigger an enforcement event are the bankruptcy or insolvency of the issuer, a default in the payment of principal or income on the ABCP and / or ABMTN, a breach in the capital loss limit test and if the ratings of the SIV fall below a certain threshold (AAA, AA). In the meanwhile if there are other occurrences like the interest rate risk limit test, FX risk limit test or liquidity requirement test the SIV is subjected to a limited cure period usually five days before the occurrence of an enforcement event. In an enforcement event, the security holders (ABCP/ ABMTN) are expected to receive interest and principal as scheduled if a prepayment option does not exist and SIV is not insolvent. SIV is not insolvent, if the sale of the assets generates enough income to repay principal and interest of the senior liabilities by depositing the same secured bank deposits.
In case the SIV asset sales proceed is not sufficient to repay all the principal and interest of the senior liabilities, insolvency event is triggered. An insolvency event is different from the enforcement event as in an insolvency event all the assets are liquidated within a short time frame. In the insolvency events the security holders, including the senior security holders are not expected to receive full payment of principal and / or interest. Proceeds from the sale of assets are shared on a pro-rata basis between the ABCP and ABMTN holders. In the nutshell these structured mechanism protects the senior liability holders and avoid any losses by providing extra protection for the senior liabilities.
9. Issuer's Perspective – Improving economies with leveraged returns
Indian banks have been observing the pressure on NII (Net Interest income) and NIM (Net Interest Margin) with increase in competition and increasing interest rate scenario. There has been significant decline in intermediation cost, which has resulted in decrease in overall return for the banks. In these scenarios, vehicles like SIV and can help the banks and financial institution to improve the overall return. The multiple benefits for the Sponsor and issuer can be summarized as under.
• Improving economies of scale and scope through the utilization of the existing balance sheet strength & operational infrastructure.
• Leveraging the treasury and investment expertise of the organization for greater profitability.
• Improving the overall NII and NIM with leveraged arbitrage of the yield curve. Sponsor usually provides the risk capital and earns very good returns on the equity capital as well as participation in capital notes.
• Leveraging the distribution channels, customer base and brand loyalty for better returns. SIV can further engage in distribution of the capital notes to investors with better margins.
• Improving their product offering across the risk reward frontier. A capital note represents the high risk and high return instruments, while ABCP and ABMTN represent the low risk and low return instruments. These instruments in desired proportion can provide structured product offering across risk reward frontier.
• Improving the fee based income by acting as sponsor and improving the utilization of existing manpower and infrastructure.
Thus we can observer that issuers can improve the economies of scale and scope with the help of SIV. Apart from that participation in capital note and risk capital improves the overall return for the issuer.
10. Investor's Perspective – Moving Across the efficient frontiers
SIV offers investors with an option for sharing the return of the yield curve arbitrage, which was till date to only banks and financial institutions. Further with levered approach SIV improves the overall return and benefit can be significant even on the smaller capital base. Some of the many benefits, which SIV offers to investors, are as under.
• Offering the investors with diversification opportunity with alternative investments like capital notes, ABCP and ABMTN etc.
• Opportunity to participate in the yield curve arbitrage with capital note.
• Investors can achieve their own desired investment frontier with combination of the Capital Note and ABCP and ABMTN. Capital notes represent the high risk and high return instruments, where as ABMTN and ABCP represents low risk and low returns instruments.
• Provides access to sophisticated products customized for the risk tolerance and return requirement.
Investors primarily benefit from the higher levered return and diversification opportunity from the SIV. However there are other possible benefits of the traditional alternative instruments. Truly speaking with the reduction in risk and by maintaining the high return, SIV instruments helps investor to achieve a positive parallel shift in their efficient frontier.
11. Success Factors
SIVs are complex structure and hence it needs inherent organization capabilities for the success. Some of the important skills and resources required for an SIV to be successful are:
• The organization structure is very crucial for the SIV. There should be different reporting line for the operations functions and day to day business management. The investments managers should be adequately resourced and there should be clear allocation of responsibilities to the asset, liability and operations teams.
• SIV demands for huge investments in infrastructure and technology to manage it's asset, liability and hedging initiatives. These systems are also required to monitor the portfolio and liability books and to ensure that they are in compliance with all the limits.
• The knowledge of markets and a market presence can be helpful in acquiring assets at attractive spreads and executing funding at competitive levels. Sound investment skill sets will also help in maintaining an attractive spread between assets and liabilities that is very necessary for future success of SIV.
• Independent control function is critical to the maintenance of the credit rating of the structured vehicle. An external oversight is provided through weekly reporting to the rating agencies, monthly reporting to the board of directors and audit by external accounting authorities.
• Economy of scale of the huge investment company can reduce the overall trade execution cost for the SIV with it's ability to transact in large trade sizes and with a wide range of counterparties.
12. Conclusion
SIV market is expected to grow as the SIV provide diversification and yield enhancement benefits to institutional investors by offering them the potential for attractive risk-adjusted returns with limited interest rate or currency exposure. Thus the investors who are willing to spend time in analyzing the complicated structures of SIV can reap the benefits of leverage yield curve arbitrage. SIV are also good for investors who are willing to invest in capital notes for high return.
Indian banks can not only reduce the pressure on NII and NIM with the help of SIV but also benefits from the economies of scale and scope as sponsor for the SIV. In a capital scarce economy like India , SIV plays an important role in capital rotation. SIVs typically invest in senior ABS/MBS securities and hence act like second level funding vehicle for the alternative investment.
SIV market growth in India will depend on the sponsor's ability to change their structures to meet the Indian market concerns. In general sponsors can continue to gain market participants confidence by continuing to increase the transparency of structure (SIV). Thus for an SIV to be successful in India , it should have a flexible structure, should be conservatively run and should have a competent management with Indian focus.
13. References
• Sunil Gangwani. “Securitization 101, the basic concepts of securitization”, Securitization Strategies Team, Deloitte & Touche.
• Comptroller's Handbook (1997). “Asset Securitization e-book”.
• ICRA Limited. “Indian Structured Finance Market Review: Asset based securitization remains the dominant asset class”.
• UBS Financial Services Inc. “Equity Linked Securities: Structured Investment”.
• V. Sridhar. “Securitization in India- opportunities & obstacles”, Discussion paper, PGP 2002 IIM Calcutta.
• Philippe Collot & Kelley Ritchey (The Alternative Investment Strategies Group of Citigroup). “Structured Investment Companies: Factors for Success”, AIMA Newsletter, June 2001.
• Perry Inglis, Juan Carlos Martorell, Katrien van Acoleyen, Nik Khakee, Thomas Kitto & Cristina Polizu. “Structured Investment Vehicle Criteria: New Developments”.
• Vinod Khothari's Securitization website. www.vinodkhothari.com.
• Merrill Lynch. “Product presentation by Merrill Lynch product development team'.
“The new yield curve arbitraging engine"
By Pradeep K Singh
CFA
--------------------------------------------------------------------------------
Arbitrage across the yield curve is not a new phenomenon for the market participants and riding the yield curve has been a primary source of income for the Banks and Financial Institutions. However the recent paradigm shift in the area of structured finance has introduced a new twist to this whole experience by leveraging the conventional technique. Structured Investment Vehicle (SIV) is one of recent entrants in this sphere of structured finance.
Structured investment vehicle or "SIV" is basically an investment company (SPV) which generates the investment returns through yield curve arbitrage by purchasing high grade (AAA, AA) medium and long term fixed income instruments and funding itself with low cost short term senior debt instruments such as Asset backed commercial paper (ABCP) and Asset backed medium term notes (ABMTN). SIV is thus a special type of CDO designed for the leveraged riding of the yield curve and generation better return for the subordinate debt (Capital Notes) and equity holders. Similar to the CDO structures, SIV funding is also classified in multiple trenches of senior and subordinate debts with residual equity funding. Typically capitalization of SIV is through a mix of equity and subordinated debt (Capital Note), which sometime is dominated by only capital notes.
SIV is one of the many instruments in the pedigree of structured finance and its origin can be traced in the Securitization ancestry. It is reminiscent to discuss the background of securitization to understand the foundation and structure of SIV.
1. Securitization in perspective
Securitization in the simple term means the creation of new securities and comes under the discipline of financial engineering. Securitization refers to the creation and issuance of new fixed income securities, whose payments of principal and interest are derived from cash flows generated by pools of assets acting as collaterals for the aforementioned securities. This structuring leads to the repackaging of cash flows into securities by adding value in terms of credibility and liquidity. Traditionally Securitization has been used a mode of financing by converting the illiquid pool of asset into more liquid marketable securities, but contemporary structuring is also motivated by higher returns, diversification, hedging objectives apart from plain vanilla funding.
Securitization history can be traced back to 1970 with the structured financing of mortgage pools in the USA . This was motivated by promotion of secondary markets in mortgages to allow liquidity for mortgage finance companies. Since the mid 1980s, better technology and more sophisticated investors have driven the asset securitization business as one of the fastest growing trend in capital markets. The growth can be visualized from the fact that outstanding securitized debt in international market is $6.6 trillion as of the second quarter of 2003 .
Indian financial market has been tardy in this area of structured initiative with its first securitization in 1991 with the Auto loan ABS issued by Citibank. Since then
Source – American Securitization Forum - Presentation before the subcommittee of the Financial Institution and Consumer Credit – United States House of representatives.
number of players and volumes have multiplied manifold. Earlier most of securitization deals have involved cars and commercial vehicles hire-purchase receivables of non-banking finance companies (NBFCs) and securitization industry in India suffered a major setback in 1997 with the crash of NBFCs. The Industry regained again in 2001 to witness the growing volumes and transaction.
Graph 1.0 – Securitization Growth in India
Source – ICRA Limited and Moody Investments Services – structured finance review.
Traditionally the growth of the securitization in the Indian market has been driven by liquidity requirements and need to manage the Asset Liability maturity mismatches similar to any other emerging economy. Though capital adequacy and aforementioned funding needs will continue to be the driver for the future growth of Indian structured finance, there will be more emphasis on better returns and leveraged arbitrage too. Hence SIV (Structured Investment Vehicle) can play an important role in achieving the multifold growth objective of the Indian Financial Institution and Banks by improving the economies of scale and scope.
2. Assortment of Structured Finance
Structured instruments come in numerous flavors ranging from the plain vanilla to complex conduits. Most widespread taxonomy is based on the underlying asset class and categories them as ABS (Asset Based Security), MBS (Mortgage Based Security), CLO (Collateralized Loan Obligations) and CBO (Collateralized Bond Obligations). The ABS is characterized by Auto loans, Credit cards, Trade Receivables as underlying pool, while MBS pool is primarily comprised of housing mortgages. CLO and CBO are jointly called CDO (Collateralized Debt Obligation) with bank loan portfolio or bond portfolio as underlying asset pool. The underlying securitized assets are also categorized based on existing and future receivables. The existing receivables are known as Asset backed, while the later known as future cash flow securitization. Also there are different types of non – asset based securitization of which securitization of future foreign exchange earning in the off shore market is very popular.
Mortgaged-backed securitization occupies greater market share in the USA , the UK and other parts of Europe , whereas in Japan and South East Asia securitization of auto loans occupies better market share. Recently mortgaged-backed securitization is also gaining popularity in Japan and Singapore . In Latin American countries securities credit cards and export receivables in the international market.
Structured finance continued to explore new frontiers of risk and return by engineering new instruments and structures. Collateralized Investment Obligation (CIO) is one of them, where bank securitize the equity investment and finally break down the cash flow of the regular dividends and growth.
Synthetic CDOs have opened new dimension to securitization by just transferring the inherent risk underlying the asset instead of transferring the cash flow from the underlying assert. Synthetic CDO at the one hand improves the risk capital return with credit default premium and on the other hand reduce the risk with diversification. These dual effects help the investors to plan a positive parallel shift in Marcowitz efficient frontier. Structured Investment Vehicle can be defined a special type of CDO with high grade debt securities in underlying pool. SIV can even have long term senior ABS and MBS securities as underlying pool for the structuring and thereby initiating the second layer of structures.
3. Structuring of Structured Investment Vehicle (SIV)
Structured Investment Vehicles (SIVs) are complex companies with similar but not identical to other Special Purpose Vehicles (SPVs) for the operational finance. SIVs demands huge investments in staffing (with analytical, hedging and cash flow modeling capabilities), technology and operational logistics. Therefore traditional banks are better positioned to operate SIVs and thereby improving the existing economies of their manpower and operational infrastructure.
SIVs act as leveraged financing vehicle to earn the spread multiple between it's long term assets i.e. Investment grade structured notes (ABS, MBS CDOs etc) or subordinated bank debt and it's short term liabilities i.e asset based commercial paper (ABCP) and asset based medium term notes (ABMTN). The vehicle targets only leveraged riding of the yield curve and try to avoid any other type of risk generated from it's asset liability structure. It tends to operate in market neutral environment and actively hedge any interest rate and foreign currency risk.
SIVs are equipped with strong structural mechanism designed to reduce risk such as defeasance event, enforcement event and insolvency event apart from regular monitoring and hedging of the interest rate and liquidity risk. Further the underlying asset of an SIV is of much higher quality than traditional ABS or MBS. Hence SIVs offer a very attractive alternative not only to traditional multi-seller ABCP conduits but it's Capital notes and MTNs offer attractive alternatives to traditional ABS & CDOs as well.
The first SIV was established in 1988 and since then not many programs has been established till date. However there is surge in demand for SIV with rising interest rate scenario in order to improve the overall returns. Similar to other traditional asset based conduits, SIV structure is also comprised of sponsor, Investment Manager, Capital note providers, Investors, liquidity provider etc. However in case of SIV, there has been increasing role of the hedge counterparties and hence most of the SIVs have direct or indirect involvement of the prominent hedge funds to manage it's market neutral environment.
SIV Sponsor is usually a investment company or bank as it is easier to reap the economies of the existing infrastructure and resources. The sponsor in the simple form can act as just sponsor and investor in the SIV for better leveraged return or may take other role such as investment manager for the investment management, treasurer for the liquidity management and risk manager for the risk mitigation of structured vehicle. Some of many roles performed by sponsor includes even operations manager, legal counsel and at time liquidity and capital provider.
In some cases these various roles are being outsourced for the specialized care and corporate governance purpose. Similar to most of the structured vehicle custodians are appointed for the management of operations and custody of the SIV assets. Some of the SIV's have outsourced the hedging activities to the specialized hedge fund and concentrate only on the investment and liquidity aspects of the SIV.
The major stakeholders in the SIVs are it's investors and capital providers and various other entities such as custodians and hedge funds are only facilitators for the smooth operation of SIV. Sponsors have a stake in SIV as they provide the majority of the SIV capital in the form of equity capital or capital notes and hence they have strong incentive to ensure maximum performance. Further due to high start-up cost, the sponsor would like to ensure the better returns to recover it's investment in SIV. Please note that unlike other traditional AB conduits, SIV sponsor is only a capital provider and underlying assets are independent. There fore credit rating of SIV's are less exposed to the credit rating of the sponsors. Further unlike traditional AB conduits, there is no need for the 100% liquidity backup and only 10% liquidity facility is provided by either sponsor or more often by several third party liquidity enhancers. Hence again the role of the sponsor is limited as compared to traditional AB conduit.
4. Composition of Assets, Liabilities and Risk Capital
SIV assets are comprised of highly rated and relatively liquid securities. Liquidity of the underlying assets reduces the overall liquidity requirement of the SIV and hence there is need of only 10% liquidity support from third party enhancement. In traditional AB conduits the liquidity enhancement may be up to 100% of the underlying asset value. A typical asset breakdown of an SIV reflects subordinated bank debts, senior classes of CDOs , ABS, MBS, long term AA and A investment grade corporate papers. However most SIVs have minimal exposure to non financial corporate debt and they prefer subordinated bank debt due to their familiarity with the product and expected high recovery rates. Though SIVs can buy the assets below investment grade too, they generally have an average portfolio rating of AA and above.
On the liability side similar to any other SPV they are multiple tranches. Senior liabilities are comprised of primarily AAA rated asset- backed commercial paper (ABCP) and asset – backed medium term notes ( ABMTN) these liabilities can be issued in multiple currencies and in multiple markets such as US and European market. The currencies and markets of the aforementioned senior liabilities are kept more or less in line with the currency of the underlying assets in order to minimize overall currency exposure. The senior liability comes under low risk and low return asset class though the overall return is better compared to similar highly rated debt securities.
Figure 2.0 – Sample SIV Balance Sheet
SIV risk capital comes from subordinated debts that are capital notes and small equity supplied by the sponsor of SIV. Capital notes comes under the high risk, high return asset class and returns are linked to leveraged yield curve arbitrage profit. Capital notes share the arbitrage profits apart from the regular fixed returns in the predefined ratios. Capital notes overall returns are effected by the leverage of SIV and directly proportional to gearing ratio. Left over profit belongs to equity capital providers and in normal circumstances generates a very high return. In case of any loss on account of change in the spread or un-hedged interest rate and currency positions, it will be first deducted from the equity capital and later will be allocated to capital note providers. Some of the SIVs do not have equity capital and use the capital notes as risk capital
5. Difference from Traditional Asset Based Conduit
SIV differs from traditional MBS and ABS primarily with respect to the underlying collateral. Traditional ABCP conduits use trade receivables, mortgages and loan as their underlying collateral, while SIVs generally use highly rated relatively liquid securities as collateral. SIV management is more disciplined with daily management of all aspects of SIV whereas ABS or MBS management comprise of less daily activities with more focus on preservation of portfolio value and monthly investor reporting. SIV also has better credit ratings (AA, A) which is independent of the sponsor rating as compared to ABS and MBS (BBB, BB). Some of the primary differences are as under :
Figure 3.0 – Comparing SIV with traditional AB conduit
6. SIV Economics
SIV economics are primarily derived from levered arbitrage across the yield curve and profit is shared by the providers of the risk capital i.e. Capital notes and equity providers. SIVs use the common principle of riding the yield curve with leveraged capital and hence the return is multifold. Further SIVs are indifferent to absolute interest rate risk as they only intend to derive their return form the spread between the underlying asset (average maturity 4-5 years) and it's liabilities (average maturity of about 6 months). Sample calculation of the return on capital note for a typical SIV is as under..
Particulars
Return computation
Spread of underlying assets
MIBOR + 50
Funding Cost (ABCP, ABMTN etc)
MIBOR + 10
Hedging fee, Trustee fee, Liquidity fee etc..
10 bps
Residual Spread
MIBOR + 30
Leverage
15 times
Overall return for SIV
MIBOR + 450
Assuming 60:40 of return sharing between capital note providers and sponsor.
Return for Capital note providers
MIBOR + 270
Return for Sponsor
MIBOR + 180
In most of the SIV structures, the Capital note provider are entitled to a base coupon, which is typically 50 to 100 bps of the residual spread and rest will depend on the leverage scenario at the time of profit distribution. As discussed above the overall return (profit) of the SIV is shared between the capital note providers and sponsor as per the predefined formulae. SIV leverage defined the risk return frontier for the risk capital providers. Lower leverage will result into lower return with low risk and higher leverage will result into the high return with high risk. Further if SIV collateral is comprised of the high rated asset with lower yields the overall return can be improved by improving the leverage without affecting the overall risk parameters. Similarly if the underlying collateral is of high return and moderate rating profile the risk can be controlled by lowering the leverage. Hence the SIV economics provides many parameters to generate the desired risk return profile.
7. Hedging and Risk Management
SIV economics and leveraged arbitraging structure is based on the premises of a market neutral environment. Hence it is imperative to completely hedge all sorts of interest rate and currency risk to derive the stipulated return from the leveraged yield curve arbitrage. SIV usually adapts to micro hedging policies in which they actively hedge each and every individual position on the asset and liability side. Dynamic hedging is an integral part of the SIV structure and a dedicated team of specialized professionals undertake this function. Some of the SIVs prefer to outsource this activity to specialized hedge funds. It has become relatively easier to perform the micro hedging with the growth in specific derivative instruments such as over night index swaps (OIS), spread swaps, etc.
Credit risks are actively counter balanced with aggressive use of the credit derivatives such as credit default swaps, total return swaps, basket default swaps, credit linked notes etc. Apart from that SIV guidelines have numerous provisions regarding initial and ongoing rating requirements and steps to be taken in the event of ratings downgrade. SIV guidelines have well defined exposure to curtail counterparty risk. Operational risk is being managed with the help of defined policies and procedures for various activities which SIV undertakes. Further most of the SIVs appoints custodians who take care of operational and regulatory issues.
The liquidity risk of SIV is managed by using maximum cumulative outflow (MCO). The MCO is equal to the largest cumulative outflows that occur during any consecutive 5 days in the up-coming 1 year period. SIVs are required to have liquidity equal to at least three times the MCO. The committed liquidity of an SIV should be generally equal to at least the MCO. SIV guidelines also define that a single liquidity facility cannot provide more than 50% of the MCO. Hence as defined above SIV resort to active management of market risk, operational risk, credit risk, liquidity risk, etc. to conform to arbitrage principles.
8. Defeasance Enforcement and Insolvency events
Structured mechanisms that are designed to reduce the risk of an SIV are defeasance event, enforcement event and insolvency event. These events defined various loss scenarios and the steps to be taken under each event. This reflects the strong guidelines for the risk management under which SIV operates. The various scenarios and related events can be defined as under.
Figure 4.0 – Structured mechanism to control risk
Widening of yield spreads or flattening of the yield curve results into losses for the SIV if it is not properly hedged and the same will affect the capital adequacy of SIV. If capital adequacy goes beyond a predefined level the defeasance event is triggered. In the defeasance process the SIV becomes less levered by suspending cash flow or dividends to the capital note holders, by selling assets or by not issuing new liabilities. The defeasance triggers differ among SIVs. Recent SIVs have seen the evolution of structures so that the SIVs have more latitude in difficult times. A defeasance trigger in an SIV would occur if the SIVs ratings fell a few notches below the SIVs targeted ratings. Thus a defeasance maintains or regains a specific rating for the SIV liability. The competency and performance of the sponsor of the SIV is critical in insuring that a defeasance event does not turn into an enforcement event.
In case the defeasance process is not successful and SIV is not able to maintain it's rating, the enforcement event is triggered. The objective of the enforcement event is to limit the further deterioration and results in the sale of the portfolio. The enforcement event provides extra protection for the holders of the SIVs ABCP and ABMTN holders. The events that would automatically trigger an enforcement event are the bankruptcy or insolvency of the issuer, a default in the payment of principal or income on the ABCP and / or ABMTN, a breach in the capital loss limit test and if the ratings of the SIV fall below a certain threshold (AAA, AA). In the meanwhile if there are other occurrences like the interest rate risk limit test, FX risk limit test or liquidity requirement test the SIV is subjected to a limited cure period usually five days before the occurrence of an enforcement event. In an enforcement event, the security holders (ABCP/ ABMTN) are expected to receive interest and principal as scheduled if a prepayment option does not exist and SIV is not insolvent. SIV is not insolvent, if the sale of the assets generates enough income to repay principal and interest of the senior liabilities by depositing the same secured bank deposits.
In case the SIV asset sales proceed is not sufficient to repay all the principal and interest of the senior liabilities, insolvency event is triggered. An insolvency event is different from the enforcement event as in an insolvency event all the assets are liquidated within a short time frame. In the insolvency events the security holders, including the senior security holders are not expected to receive full payment of principal and / or interest. Proceeds from the sale of assets are shared on a pro-rata basis between the ABCP and ABMTN holders. In the nutshell these structured mechanism protects the senior liability holders and avoid any losses by providing extra protection for the senior liabilities.
9. Issuer's Perspective – Improving economies with leveraged returns
Indian banks have been observing the pressure on NII (Net Interest income) and NIM (Net Interest Margin) with increase in competition and increasing interest rate scenario. There has been significant decline in intermediation cost, which has resulted in decrease in overall return for the banks. In these scenarios, vehicles like SIV and can help the banks and financial institution to improve the overall return. The multiple benefits for the Sponsor and issuer can be summarized as under.
• Improving economies of scale and scope through the utilization of the existing balance sheet strength & operational infrastructure.
• Leveraging the treasury and investment expertise of the organization for greater profitability.
• Improving the overall NII and NIM with leveraged arbitrage of the yield curve. Sponsor usually provides the risk capital and earns very good returns on the equity capital as well as participation in capital notes.
• Leveraging the distribution channels, customer base and brand loyalty for better returns. SIV can further engage in distribution of the capital notes to investors with better margins.
• Improving their product offering across the risk reward frontier. A capital note represents the high risk and high return instruments, while ABCP and ABMTN represent the low risk and low return instruments. These instruments in desired proportion can provide structured product offering across risk reward frontier.
• Improving the fee based income by acting as sponsor and improving the utilization of existing manpower and infrastructure.
Thus we can observer that issuers can improve the economies of scale and scope with the help of SIV. Apart from that participation in capital note and risk capital improves the overall return for the issuer.
10. Investor's Perspective – Moving Across the efficient frontiers
SIV offers investors with an option for sharing the return of the yield curve arbitrage, which was till date to only banks and financial institutions. Further with levered approach SIV improves the overall return and benefit can be significant even on the smaller capital base. Some of the many benefits, which SIV offers to investors, are as under.
• Offering the investors with diversification opportunity with alternative investments like capital notes, ABCP and ABMTN etc.
• Opportunity to participate in the yield curve arbitrage with capital note.
• Investors can achieve their own desired investment frontier with combination of the Capital Note and ABCP and ABMTN. Capital notes represent the high risk and high return instruments, where as ABMTN and ABCP represents low risk and low returns instruments.
• Provides access to sophisticated products customized for the risk tolerance and return requirement.
Investors primarily benefit from the higher levered return and diversification opportunity from the SIV. However there are other possible benefits of the traditional alternative instruments. Truly speaking with the reduction in risk and by maintaining the high return, SIV instruments helps investor to achieve a positive parallel shift in their efficient frontier.
11. Success Factors
SIVs are complex structure and hence it needs inherent organization capabilities for the success. Some of the important skills and resources required for an SIV to be successful are:
• The organization structure is very crucial for the SIV. There should be different reporting line for the operations functions and day to day business management. The investments managers should be adequately resourced and there should be clear allocation of responsibilities to the asset, liability and operations teams.
• SIV demands for huge investments in infrastructure and technology to manage it's asset, liability and hedging initiatives. These systems are also required to monitor the portfolio and liability books and to ensure that they are in compliance with all the limits.
• The knowledge of markets and a market presence can be helpful in acquiring assets at attractive spreads and executing funding at competitive levels. Sound investment skill sets will also help in maintaining an attractive spread between assets and liabilities that is very necessary for future success of SIV.
• Independent control function is critical to the maintenance of the credit rating of the structured vehicle. An external oversight is provided through weekly reporting to the rating agencies, monthly reporting to the board of directors and audit by external accounting authorities.
• Economy of scale of the huge investment company can reduce the overall trade execution cost for the SIV with it's ability to transact in large trade sizes and with a wide range of counterparties.
12. Conclusion
SIV market is expected to grow as the SIV provide diversification and yield enhancement benefits to institutional investors by offering them the potential for attractive risk-adjusted returns with limited interest rate or currency exposure. Thus the investors who are willing to spend time in analyzing the complicated structures of SIV can reap the benefits of leverage yield curve arbitrage. SIV are also good for investors who are willing to invest in capital notes for high return.
Indian banks can not only reduce the pressure on NII and NIM with the help of SIV but also benefits from the economies of scale and scope as sponsor for the SIV. In a capital scarce economy like India , SIV plays an important role in capital rotation. SIVs typically invest in senior ABS/MBS securities and hence act like second level funding vehicle for the alternative investment.
SIV market growth in India will depend on the sponsor's ability to change their structures to meet the Indian market concerns. In general sponsors can continue to gain market participants confidence by continuing to increase the transparency of structure (SIV). Thus for an SIV to be successful in India , it should have a flexible structure, should be conservatively run and should have a competent management with Indian focus.
13. References
• Sunil Gangwani. “Securitization 101, the basic concepts of securitization”, Securitization Strategies Team, Deloitte & Touche.
• Comptroller's Handbook (1997). “Asset Securitization e-book”.
• ICRA Limited. “Indian Structured Finance Market Review: Asset based securitization remains the dominant asset class”.
• UBS Financial Services Inc. “Equity Linked Securities: Structured Investment”.
• V. Sridhar. “Securitization in India- opportunities & obstacles”, Discussion paper, PGP 2002 IIM Calcutta.
• Philippe Collot & Kelley Ritchey (The Alternative Investment Strategies Group of Citigroup). “Structured Investment Companies: Factors for Success”, AIMA Newsletter, June 2001.
• Perry Inglis, Juan Carlos Martorell, Katrien van Acoleyen, Nik Khakee, Thomas Kitto & Cristina Polizu. “Structured Investment Vehicle Criteria: New Developments”.
• Vinod Khothari's Securitization website. www.vinodkhothari.com.
• Merrill Lynch. “Product presentation by Merrill Lynch product development team'.