SIVs and the 2007 Conduit Run
Structured investment vehicles borrowed short-term commercial paper to buy long-term structured credit, and when that short-term funding vanished in 2007 the mismatch forced fire sales that helped ignite the financial crisis.
Prerequisites: What Securitization Does and Why It Exists, ABS CDOs and the 2008 Correlation Failure
A bank that funds 30-year mortgages with overnight deposits is doing something depositors implicitly trust it can handle, because deposit insurance and a central bank backstop stand behind it if depositors all want their money at once. A structured investment vehicle (SIV) did the same maturity mismatch — funding long-dated structured credit with short-term borrowing — with none of that backstop, run out of an off-balance-sheet entity most bank shareholders never even saw on the balance sheet.
A SIV bought long-maturity, higher-yielding structured credit assets and funded the purchase by rolling over short-term asset-backed commercial paper (ABCP) every few weeks or months. It earned the spread between the two as long as it could keep refinancing. When investors stopped buying that commercial paper in 2007, SIVs couldn't roll their funding and were forced to sell assets into a market with no buyers.
The mismatch that worked until it didn't
A SIV's assets were long-dated: RMBS, CDO tranches, and other structured credit paying a spread over benchmark rates, often with maturities of many years. Its liabilities were short: commercial paper and medium-term notes that had to be reissued constantly, sometimes every 30 to 90 days. This funded a healthy spread in normal markets, since long-dated assets typically yield more than short-term borrowing costs — but it meant the SIV had to successfully find new short-term lenders on every single rollover date, forever, with no ability to simply wait out a bad week.
Worked example
A SIV holds $10 billion of structured credit assets yielding 6%, funded entirely with 90-day commercial paper costing 5.2%, earning an 0.8-point annualized spread, or roughly $80 million a year on the full $10 billion. In August 2007, as concerns spread about subprime-linked assets, commercial paper investors stop rolling their holdings into new SIV paper at any price. With $2.5 billion of that paper maturing in the next 30 days and no new buyers, the SIV cannot repay maturing paper out of ordinary income — its underlying assets don't mature for years — so it must either draw an emergency bank credit line (if one exists) or sell assets at whatever price the market offers, often well below face value, to raise cash immediately.
What this means in practice
The 2007 conduit run showed that "short-term funding a long-term asset" is a risk regardless of the borrower's credit quality — even AAA-rated structured credit became unsellable at anything near fair value once buyers of the short-term paper funding it disappeared simultaneously. Regulators responded with liquidity coverage requirements that specifically target this mismatch inside regulated banks.
The 2007 SIV failures were not primarily a story of bad loans defaulting — many SIV assets eventually paid close to what was expected. The failure was a funding failure: an entity structurally unable to survive even a temporary closure of its short-term borrowing market, regardless of the ultimate quality of what it owned.
Related concepts
Practice in interviews
Further reading
- Gorton, Slapped by the Invisible Hand: The Panic of 2007 (ch. on shadow banking)