Worldwide capital markets now recognize structured investment vehicles (SIVs) as an asset class, and the sector is poised for growth in 1999. SIVs showed great resilience in the face of market upheaval in 1998, and interest from potential issuers is presently very strong, both at the inquiry and developmental stages.
Standard & Poor's has rated seven such entities during the past 10 years, and current total debt outstanding of all SIVs is approximately $40 billion, an increase of 19% from 1998. It is estimated that total debt outstanding will hit $55 billion by year end 1999. One new vehicle has already been rated in 1999, and at least two more new ratings are anticipated this year, as well as several others over the next few years.
Surviving Market Volatility In 1998
SIVs are credit arbitrage vehicles that issue debt in the U.S. and European asset-backed commercial paper (ABCP) and medium-term note (MTN) markets. With the proceeds of this issuance, they purchase securities of varying credit quality and maturity, and use derivative transactions to manage market risk and the cash flows. As a result, they attempt to pick up the credit spread between their assets and liabilities because they commit themselves to maintaining market risk neutrality. Examples of this types of entity include Beta Finance Inc., Centauri Corp., and Sigma Finance Corp.
1998 was a very interesting year for SIVs. This asset class demonstrated its ability to withstand economic turmoil given the diversity of the operating environment. The beginning of the year saw the continued tightening of credit spreads, and the quest to purchase new or different asset classes was imperative to the maintenance of existing profit margins. The turmoil of the latter half of 1998 resulted in significant widening of credit spreads, the effect of which was threefold for the SIVs. First, it meant that assets currently held in the portfolio were reduced in value. Second, the funding levels for the SIVs themselves became more expensive. Finally, new assets purchased by the SIVs had significantly higher yields than had been witnessed in previous years.
Overall, however, these three happenings have not had any adverse impact on the ratings of the SIVs. Although the SIV funding levels increased, causing these entities to be more expensive, the increase was substantially less than for most other asset classes. Furthermore, the SIV commercial paper was well received in what was, at times, a less liquid and expensive ABCP market. At no point in time did any of the SIVs need to call upon liquidity facilities to repay maturing debt, and all debt was rolled over in the market.
Credit spreads for eligible SIV investments are not as erratic now, and have tightened from the height of the market turmoil: but they have not returned to pre-turmoil levels. This is also true of the funding costs of the SIVs. However, the SIV now typically funds in the CP market at one to three basis points more than pre-turmoil levels, which compares very favorably with many other asset classes.
SIVs Prove Their Resilience
Although most or all of the assets held in SIV portfolios decreased in value during late 1998 and early 1999, performance during this time was a true testament to the resilience of the SIVs, the amount of capital that was maintained, and the active management of the SIVs' investment managers. All SIVs continue to be rated 'AAA/A-1+' by Standard & Poor's. In addition, it is now possible to back test the capital charges that are applied to the assets held by the SIVs. These charges have been adequate to withstand the turmoil of recent months given daily marking to market of the portfolios.
On a particularly positive note for the SIVs, spreads were at their widest for years. Therefore, new asset purchases will yield significantly more than experienced in recent years, and because spreads have widened more than the funding levels of the SIVs, the potential for increased spread yield on new asset purchases in 1999 is strong. It must also be pointed out that at this time, the funding levels of the SIVs have practically reverted to pre-August 1998 levels, and one of the U.S. ABCP programs—Sigma Finance, rated in January 1995—could issue more than $10 billion in 1999.
It must be said that the asset/liability funding gap and leverage maintained by the SIVs before, and especially during the recent market turmoil, had a significant impact on the manner in which they weathered the storm. During such a time, the active management of the portfolio becomes a significant determinant. If a comfort zone of excess capital is maintained, then obviously an erosion of the capital base due to a decrease in mark-to-market value will require a less immediate reaction. If an entity is operating at its leverage cap, it is not allowing itself any room to maneuver; it must de-leverage to continue to pass all tests and limit requirements. In an environment such as the last quarter of 1998, selling assets wasn't always easy. SIVs are actively managed by their investment managers, and it is their responsibility to decide which assets represent the best value to the portfolio at all times. Assets are normally purchased with the view to holding them to maturity, but it does not always necessarily mean that investment managers will do so.
New Players In The Market
There has already been one new SIV rating in 1999—K2 Corp., managed by Dresdner Bank AG London Branch. In 1998 there was one new program rated: Dorada Corp., managed by Citibank International PLC, which brings the total number of SIVs managed by Citibank to three. One SIV also matured during 1998: Alpha Finance Corp. However, Alpha was the very first SIV to be rated, back in 1988, and it was structured to mature in 1998. The more recently rated SIVs are not intended to operate for a finite period of time. Instead, they now have the capacity to have a rolling or extended maturity date given that certain parameters are met.
These types of vehicles involve quite a large number of participants, i.e., the capital note holders, the liquidity providers, the dealers, the issuers, paying agents, the investment managers, legal staff, the rating agencies, etc., and it can be lengthy process in the absence of sufficient timely preparation. Certainly market turmoil will also have an impact if it is perceived that conditions are unsuitable. Standard & Poor's welcomes the opportunity to discuss rating requirements with prospective clients very early in their plans in an attempt to smooth the process.
Can SIVs Transact In Credit Derivatives
One request that appears to be completely consistent across the spectrum of inquiries is the ability of these vehicles to transact in credit derivatives. Standard & Poor's is currently studying these requests since there are a number of different issues that arise, including documentation issues, the liquidity and depth of the market, appropriate capital charges and pricing. The role of these transactions in the event of enforcement of a SIV must also be considered. Enforcement is triggered upon the breach of pre-agreed limits, and the security trustee, acting on behalf of the secured creditors, will crystallize the lien on the SIV assets to manage the portfolio to ensure that all obligations are repaid in a timely manner. Therefore, if the SIV has entered into a transaction that has effectively created an unfunded synthetic asset, the question is how should such transactions be treated by the security trustee in the event of enforcement?
As markets evolve over time, the eligible types of assets, derivatives, and transactions in the SIV portfolio are envisioned to change. The use of more sophisticated risk modeling, and access to more information, will facilitate this process. However, the integrity of these vehicles, and the maintenance of the 'AAA/A-1+' ratings, require that the process of change is very carefully managed. That way, SIVs as an asset class can continue to prudently grow.
