The SIV epidemic

SIVs were in the business of borrowing short and lending long. Now that the subprime crunch has cast doubt on the value of assets they were borrowing short against, they’re in a world of hurt, and so are the big financial institutions that sponsored them. If they have to dump their assets, the liquidity squeeze will get worse. But that’s life in the big city; the Treasury shouldn’t bail them out, or pressure the less greedy financial institutions to help bail out the more greedy and stupid ones.

Thanks to Peter Cohan, I finally understand what a Structured Investment Vehicle (SIV) is: it’s a leveraged investment fund sponsored by a big financial institution that trades on the parent company’s reputation but is off its balance sheet. The extent to which the parent is legally liable if the fund goes belly-up seems to vary from case to case, but as a matter of maintaining business reputation the pressure on the parent firms to bail out the SIVs is strong.

The leverage comes from the SIVs’ capacity (based on their parents’ credit and credibility) to sell asset-based commercial paper. In English, that means that they operate by borrowing short-term money to lend long-term money. Borrowing short and lending long was the basic source of the S&L crisis (though of course mismanagement, moral hazard, and outright theft all contributed to the debacle). That is to say, SIVs were in business to do something insanely risky and stupid. Now that the subprime mortgage meltdown, and the revelation that a AAA rating on an asset-backed security doesn’t actually mean that security is … well, secure … have made asset-backed commercial paper hard to sell, the SIVs are up the proverbial polluted estuary with no apparent means of propulsion. They can’t sell their assets for anything like their underlying value, because the opacity of the instruments and the uncertainties in the housing markets means that no one really knows what that value is, and every potential buyer has to worry that the potential seller is simply trying to offload toxic waste. With the financial institutions’ own solvency in question because no one knows how big the losses are or how big any single institution’s exposure is, their ability to borrow money on their own account is also compromised.

How to divide up the losses among the investors and the parent financial firms is going to be complicated, but I’m with Peter: the appropriate taxpayer share of the losses is zero, and the Treasury shouldn’t bully the financial institutions who in this instance were less stupid and greedy to help bail out those that were more stupid and greedy.

The temptation to “do something” is obvious: if the SIVs have to dump their holdings at fire-sale prices, other holders of similar assets, when they mark them to market, are going to show gigantic losses, further shaking confidence. But we pay Treasury Secretaries and central banks to resist that sort of temptation. Maybe if a Very Big Bank goes under that will help remind future bank CEOs that it’s not actually necessary to dance as long as the music is playing. There need to be some rewards for sitting down first.

Il est bon de tuer de temps en temps un amiral pour encourager les autres.*

Update Apparently something’s going to be unveiled tomorrow.

* Voltaire, on the execution of Admiral Byng: “It is good to kill an admiral from time to time, to encourage the others.” (The pun is on encourager, which can have either the meaning of “encourage” as the word is used in English or the more literal meaning “put courage into.”)

Author: Mark Kleiman

Professor of Public Policy at the NYU Marron Institute for Urban Management and editor of the Journal of Drug Policy Analysis. Teaches about the methods of policy analysis about drug abuse control and crime control policy, working out the implications of two principles: that swift and certain sanctions don't have to be severe to be effective, and that well-designed threats usually don't have to be carried out. Books: Drugs and Drug Policy: What Everyone Needs to Know (with Jonathan Caulkins and Angela Hawken) When Brute Force Fails: How to Have Less Crime and Less Punishment (Princeton, 2009; named one of the "books of the year" by The Economist Against Excess: Drug Policy for Results (Basic, 1993) Marijuana: Costs of Abuse, Costs of Control (Greenwood, 1989) UCLA Homepage Curriculum Vitae Contact: